Working Paper: NBER ID: w26053
Authors: Lilia Maliar; John B. Taylor
Abstract: During the 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 size of the smallest root (or eigenvalue) captures model dynamics better than the underlying parameters. We argue that the puzzle occurs under very special empirically implausible and socially sub-optimal monetary policy rules, whereas empirically relevant Taylor rules lead to sensible implications.
Keywords: Forward guidance; Monetary policy; New Keynesian model
JEL Codes: C5; E4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| forward guidance (E60) | economic outcomes (F61) |
| monetary policy rule (E52) | impact of forward guidance (E60) |
| inflation coefficient < 1 (E31) | stable root (C62) |
| stable root (C62) | multiple equilibria (D50) |
| inflation coefficient = 1 (E31) | forward guidance puzzle (C54) |
| inflation coefficient > 1 (E31) | no forward guidance puzzle (D84) |
| closed-form solutions (C69) | model dynamics (C69) |