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Forward guidance and the state of the economy

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This paper examines forward guidance using a nonlinear New Keynesian model with a zero lower bound (ZLB) constraint on the nominal interest rate. Forward guidance is modeled with news shocks to the monetary policy rule. The effectiveness of forward guidance depends on the state of the economy, the speed of the recovery, the ZLB constraint, the degree of uncertainty, the monetary response to inflation, the size of the news shocks, and the forward guidance horizon. Specifically, the stimulus from forward guidance falls as the economy deteriorates or as households expect a slower recovery. When the ZLB binds, less uncertainty about the economy or an expectation of a stronger response to inflation reduces the benefit of forward guidance. Forward guidance via a news shock is less stimulative than an unanticipated monetary policy shock around the steady state, but a news shock is more stimulative near the ZLB and always has a larger cumulative effect on output. When the central bank extends the forward guidance horizon, the cumulative effect initially increases but then decreases. These results indicate that there are limits to the stimulus forward guidance can provide, but that stimulus is largest when the news is communicated early in a recession.

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File URL: http://www.dallasfed.org/assets/documents/research/papers/2016/wp1612.pdf
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Paper provided by Federal Reserve Bank of Dallas in its series Working Papers with number 1612.

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Length: 40 pages
Date of creation: 08 Nov 2016
Date of revision: 19 May 2016
Handle: RePEc:fip:feddwp:1612
DOI: 10.24149/wp1612
Contact details of provider: Web page: http://www.dallasfed.org/
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