DP13383 | Forward Guidance: Is It Useful After the Crisis?

Publication Date

12/10/2018

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Abstract

During recent economic crisis, when nominal interest rates were at their effective lower bounds, central banks used forward guidance -- announcements about future policy rates -- to conduct their monetary policy. Many policymakers believe that forward guidance will remain in use after the end of the crisis, however, there is uncertainty about its effectiveness. In this paper, we study the impact of forward guidance in a stylized new Keynesian economy away from the effective lower bound on nominal interest rates. Using closed-form solutions, we show that the impact of forward guidance on the economy depends critically on a specific monetary policy rule, ranging from non-existing to immediate and unrealistically large, the so-called forward guidance puzzle. We show that the puzzle occurs under very special -- empirically implausible and socially suboptimal -- monetary policy rules, whereas empirically relevant Taylor rules lead to sensible implications.