The Fiscal Forward Guidance Puzzle and a Resolution

52 Pages Posted: 20 Dec 2017

See all articles by Matthew B. Canzoneri

Matthew B. Canzoneri

Georgetown University

Dan Cao

Georgetown University - Department of Economics

Robert E. Cumby

Georgetown University - Department of Economics; National Bureau of Economic Research (NBER)

Behzad Diba

Georgetown University

Wenlan Luo

Tsinghua University - School of Economics & Management

Date Written: September 16, 2017

Abstract

The forward fiscal guidance puzzle pertains to New Keynesian models when monetary policy is temporarily caught in a liquidity trap: (1) expected future fiscal shocks have an unbelievably large effect on current inflation, and (2) the effect on current inflation is larger the further out is the shock expected to occur. We illustrate the problem analytically. Then, we use Blue Chip inflation forecasts to argue that the effects on inflation expectations should be small. And finally, we analyze two potential resolutions to the puzzle. The first is the Fiscal Theory of the Price Level. In a calibrated model with price inertia, investment, and long-term debt, we show that the Fiscal Theory resolves the second aspect of the puzzle, but certainly not the first. In our preferred resolution we return to a Ricardian fiscal policy. And we assume that the probability of a return to the Taylor Rule depends on the rate of inflation. The model's predictions are in line with the evidence from the Blue Chip forecasts.

Keywords: Anticipated Fiscal Policy, Zero Lower Bound, Monetary Policy Normalization

JEL Classification: E52, E62, E63

Suggested Citation

Canzoneri, Matthew B. and Cao, Dan and Cumby, Robert E. and Diba, Bezhad and Luo, Wenlan, The Fiscal Forward Guidance Puzzle and a Resolution (September 16, 2017). Journal of Economic Dynamics and Control, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3089199

Matthew B. Canzoneri

Georgetown University ( email )

Washington, DC 20057
United States
202-687-5911 (Phone)
202-687-6102 (Fax)

Dan Cao (Contact Author)

Georgetown University - Department of Economics ( email )

Washington, DC 20057
United States

Robert E. Cumby

Georgetown University - Department of Economics ( email )

580 Intercultural Center
Washington, DC 20057
United States
202-687-2990 (Phone)
202-687-6102 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Bezhad Diba

Georgetown University ( email )

Washington, DC 20057
United States
2026875682 (Phone)
2026876102 (Fax)

HOME PAGE: http://econ.georgetown.edu/

Wenlan Luo

Tsinghua University - School of Economics & Management ( email )

Beijing, 100084
China

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