DP9975 | Macro coordination: Forward Guidance as ?cheap talk??

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In the context of revived output growth and business confidence in the UK, we analyse forward guidance as a ?coordination device?, indicating that monetary accommodation will be available for a welcome and long-awaited shift out of prolonged recession. As David Miles has emphasised, however, the existence of multiple equilibria is a necessary condition for costless and non-binding messages ? so-called ?cheap talk? ? to act in this way. By way of microfoundations, we appeal to Peter Diamond?s classic model of search, where the positive externalities offered by ?thick? markets can generate different equilibrium levels of production. What of the objection that ?cheap talk? by the MPC may be used deliberately to mislead the Private Sector in order to assist the MPC achieve its objectives? We show that this is not true for symmetric inflation targeting, where ?cheap talk? selects the Pareto dominant equilibrium. (This contrasts with the case where high inflation is penalised, but not below target inflation).