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Versatile Forward Guidance: Escaping or Switching?

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  • Gersbach, Hans
  • Liu, Yulin
  • Tischhauser, Martin

Abstract

We examine how forward guidance should be designed when an economy faces negative natural real interest-rate shocks and subsequent supply shocks. Besides a standard approach for forward guidance, we introduce two flexible designs: escaping and switching. With escaping forward guidance, the central banker commits to low interest rates in the presence of negative natural real interest-rate shocks, contingent on a self-chosen inflation rate threshold. With switching forward guidance, the central banker can switch from interest-rate forecasts to inflation forecasts any time in order to stabilize supply shocks. We show that for small and large natural real interest-rate shocks, escaping forward guidance is preferable to any of the other approaches, while switching forward guidance is optimal for intermediate natural real interest-rate shocks. Furthermore, with the polynomial chaos expansion method, we show that our findings are globally robust to parameter uncertainty. In addition, using Sobol' Indices, we identify the structural parameters with the greatest effect on the results.

Suggested Citation

  • Gersbach, Hans & Liu, Yulin & Tischhauser, Martin, 2018. "Versatile Forward Guidance: Escaping or Switching?," CEPR Discussion Papers 12559, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:12559
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    More about this item

    Keywords

    central banks; forward guidance; global robustness; polynomial chaos expansion; Sobol' Indices; transparency; zero lower bound;

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E49 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Other
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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