Limitations on the Effectiveness of Forward Guidance at the Zero Lower Bound

52 Pages Posted: 11 Jan 2010

See all articles by Andrew T. Levin

Andrew T. Levin

affiliation not provided to SSRN

David Lopez-Salido

Board of Governors of the Federal Reserve System

Edward Nelson

Board of Governors of the Federal Reserve System

Tack Yun

Federal Reserve Board - Division of Monetary Affairs

Date Written: November 2009

Abstract

The recent literature on monetary policy in the presence of a zero lower bound on interest rates has shown that forward guidance regarding the path of interest rates can be very effective in preserving macroeconomic stability in the face of a contractionary demand shock; moreover, that literature apparently leaves little scope for any further improvements in stabilization performance via nontraditional monetary policies. In this paper, we characterize optimal policy under commitment in a prototypical New Keynesian model and examine whether those conclusions are sensitive to the specification of the shock process and to the interest elasticity of aggregate demand. Although forward guidance is effective in offsetting natural rate shocks of moderate size and persistence, we find that the macroeconomic outcomes are much less appealing for larger and more persistent shocks, especially when the interest elasticity parameter is set to values widely used in the literature. Thus, while forward guidance could be sufficient for mitigating the effects of a 'Great Moderation'-style shock, a combination of forward guidance and other monetary policy measures - such as large-scale asset purchases - might well be called for in responding to a 'Great Recession'-style shock.

Keywords: Forward Guidance, Optimal Policy under Commitment, Zero Lower Bound

JEL Classification: E32, E43, E52

Suggested Citation

Levin, Andrew and Lopez-Salido, David and Nelson, Edward and Yun, Tack, Limitations on the Effectiveness of Forward Guidance at the Zero Lower Bound (November 2009). CEPR Discussion Paper No. DP7581. Available at SSRN: https://ssrn.com/abstract=1533186

Andrew Levin (Contact Author)

affiliation not provided to SSRN

David Lopez-Salido

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Edward Nelson

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Tack Yun

Federal Reserve Board - Division of Monetary Affairs ( email )

20th and C Streets, NW
Washington, DC 20551
United States

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