We assess the power of forward guidance — promises about future interest rates — as a monetary tool in a liquidity trap using a quantitative incomplete-markets model. Our results suggest the effects of forward guidance are negligible. A commitment to keep future nominal interest rates low for a few quarters—although macro indicators suggest otherwise—has only trivial effects on current output and employment. We explain theoretically why in complete markets models forward guidance is powerful—generating a “forward guidance puzzle”—and why this puzzle disappears in our model. We also clarify theoretically ambiguous conclusions from previous research about the effectiveness of forward guidance in incomplete and complete markets models.
Bibliographical noteWe thank our discussants Jeffrey R. Campbell, Jeff Lacker, Ralph Luetticke for many detailed comments. We thank participants of the Carnegie-Rochester Conference Series on Public Policy, the conference on “Heterogeneity in Macroeconomics, A Decade after the Crisis”, MacCaLM Summer Workshop, NBER Summer Institute Dynamic Equilibrium Models group, the conference on “Credit Market Frictions, Business Cycles, and Monetary Policy: A Research Conference in Honor of Charles Carlstrom and Timothy Fuerst”, the 1st European Midwest Micro/Macro Conference, the Stanford Institute for Theoretical Economics (SITE) group on Macroeconomics and Inequality, and seminar participants at Banco de Portugal, the Deutchse Bundesbank Trinity Webinar, the National Bank of Poland, Oxford University, Sveriges Riksbank, and the University of Cologne. We gratefully acknowledge financial support from the National Science Foundation Grant No. SES-1357903 , FRIPRO Grant No. 250617, and the Ragnar Söderbergs stiftelse. This project has received funding from the European Research Council (ERC) under the European Union’s Horizon 2020 research and innovation programme grant agreement No 759482.
Publisher Copyright: © 2019 Elsevier B.V.
- Forward guidance
- Incomplete markets
- Liquidity trap