Forward Guidance under Imperfect Information: Instrument Based or State Contingent?

49 Pages Posted: 13 Nov 2019

See all articles by Chengcheng Jia

Chengcheng Jia

Federal Reserve Banks - Federal Reserve Bank of Cleveland

Date Written: November 05, 2019

Abstract

I study the optimal type of forward guidance in a flexible-price economy in which both the private sector and the central bank are subject to imperfect information about the aggregate state of the economy. In this case, forward guidance changes the private sector’s expectations about both future monetary policy and the state of the economy. I study two types of forward guidance. The first type is instrument based, in which case the central bank commits to a value of the policy instrument. The second type is state contingent, in which case the central bank reveals its imperfect information and commits to a policy response rule. The key message is that forward guidance allows the central bank to reduce ex-ante price fluctuations by making the optimal trade-off between price deviations after the actual shock and after the noise shock. However, this benefit comes with a cost under the instrument-based forward guidance; that is, since firms perfectly know the change in monetary policy and prices are fully flexible, the real output level becomes independent of monetary policy. Consequently, while state-contingent forward guidance guarantees ex-ante welfare improvement, instrument-based forward guidance improves ex-ante welfare only if the central bank’s information is sufficiently precise.

JEL Classification: D82, D83, E52, E58

Suggested Citation

Jia, Chengcheng, Forward Guidance under Imperfect Information: Instrument Based or State Contingent? (November 05, 2019). FRB of Cleveland Working Paper No. 19-22, Available at SSRN: https://ssrn.com/abstract=3485748 or http://dx.doi.org/10.2139/ssrn.3485748

Chengcheng Jia (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Cleveland ( email )

East 6th & Superior
Cleveland, OH 44101-1387
United States

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