Working Paper: NBER ID: w20882
Authors: Alisdair McKay; Emi Nakamura; J. N. Steinsson
Abstract: In recent years, central banks have increasingly turned to “forward guidance” as a central tool of monetary policy, especially as interest rates around the world have hit the zero lower bound. Standard monetary models imply that far future forward guidance is extremely powerful: promises about far future interest rates have huge effects on current economic outcomes, and these effects grow with the horizon of the forward guidance. We show that the power of forward guidance is highly sensitive to the assumption of complete markets. If agents face uninsurable income risk and borrowing constraints, a precautionary savings effect tempers their responses to changes in future interest rates. As a consequence, forward guidance has substantially less power to stimulate the economy. In addition, we show that the business cycle dynamics of our incomplete markets model differ substantially from its complete market counterpart. This contrasts with the well-known results of Krusell and Smith (1998). We present approximate representations that can easily be incorporated into standard business cycle models.
Keywords: Forward Guidance; Monetary Policy; Incomplete Markets
JEL Codes: E21; E40; E50
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Forward Guidance (F17) | Consumption (E21) |
| Forward Guidance (F17) | Output (Y10) |
| Promise of Lower Future Interest Rates (E43) | Consumption (E21) |
| Promise of Lower Future Interest Rates (E43) | Output (Y10) |
| Incomplete Markets (D52) | Effect of Forward Guidance on Output (E60) |
| Precautionary Savings (D14) | Effect of Forward Guidance (E60) |
| Horizon of Forward Guidance (E60) | Effectiveness of Forward Guidance (E60) |