Working Paper: NBER ID: w24521
Authors: Marcus Hagedorn; Jinfeng Luo; Iourii Manovskii; Kurt Mitman
Abstract: 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.
Keywords: Forward Guidance; Monetary Policy; Liquidity Trap; Incomplete Markets
JEL Codes: E21; E30; E52; E58; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Forward guidance policy (E61) | current output (C67) |
| Forward guidance policy (E61) | employment (J68) |
| Intertemporal substitution effect weakened (D15) | minimal demand response (R22) |
| Future changes in nominal rates (E43) | contemporaneous output effects (F62) |
| Nominal rigidities and partially nominal government budget (E62) | muted effects of forward guidance (E60) |