Forward guidance with unanchored expectations

Stefano Eusepi, Christopher Gibbs and Bruce Preston

No 11/2021, Bank of Finland Research Discussion Papers from Bank of Finland

Abstract: We study zero interest-rate policy in response to a large negative demand shock when long-run expectations can fall over time. Because falling expectations make monetary policy less effective by raising real interest rates, the optimal forward guidance policy makes large front-loaded promises to stabilize expectations. Policy is too stimulatory in the event of transitory shocks, but provides insurance against persistent shocks. The optimal policy is well-approximated by a constant calendar-based forward guidance, independent of the shock's realised persistence. The insurance property distinguishes our paper from other bounded rationality papers that solve the forward guidance puzzle and generates important quantitative differences.

Keywords: Optimal Monetary Policy; Learning Dynamics; Expectations Stabilization; Forward Guidance (search for similar items in EconPapers)
JEL-codes: D83 D84 E32 (search for similar items in EconPapers)
Date: 2021
New Economics Papers: this item is included in nep-dge and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:zbw:bofrdp:rdp2021_011

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