DP12231 | The Puzzle, the Power, and the Dark Side: Forward Guidance Redux

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Forward guidance (FG) is phenomenally powerful in New Keynesian models---a feature that earned the label "FG puzzle". This paper shows formally how two channels are jointly necessary to reduce the power enough to resolve the puzzle: hand-to-mouth constrained households' income respond to aggregate less than one-to-one; and unconstrained households self-insure idiosyncratic risk. These channels are complementary: if the former condition fails, FG power is instead amplified and the puzzle aggravated. Yet optimal policy does not imply larger FG duration even with such puzzling amplification, because FG power has a dark side: when it increases, so does its welfare cost.