Household Debt and the Heterogeneous Effects of Forward Guidance

38 Pages Posted: 2 Dec 2019 Last revised: 29 Apr 2020

See all articles by Francesco Ferrante

Francesco Ferrante

Board of Governors of the Federal Reserve System

Matthias O. Paustian

Board of Governors of the Federal Reserve System

Date Written: November, 2019

Abstract

We develop an incomplete-markets heterogeneous agent New-Keynesian (HANK) model in which households are allowed to lend and borrow, subject to a borrowing constraint. We show that, in this framework, forward guidance, that is the promise by the central bank to lower future interest rates, can be a powerful policy tool, especially when the economy is in a liquidity trap. In our model, the power of forward guidance is amplified by three redistributive channels, absent in a representative agent new- Keynesian model (RANK) or in a HANK model without private debt. First, expected lower rates imply a future transfer of wealth from savers to borrowers, reducing precautionary motives and stimulating current demand and inflation. Second, higher initial inflation lowers the path of the real rate increasing the wealth of borrowers, who have a higher marginal propensity to consume (MPC). Third, if debt is nominal, debt deflation generates also a wealth transfer towards high-MPC borrowing-constrained agents, further increasing aggregate consumption and inflation. These channels amplify each other in a liquidity trap, and can make forward guidance more powerful in a HANK model than in a RANK framework. These results contrast with previous research on HANK models, which focused on frameworks where agents were not allowed to borrow, and which found negligible effects of forward guidance.

JEL Classification: E21, E32, E52, E58

Suggested Citation

Ferrante, Francesco and Paustian, Matthias O., Household Debt and the Heterogeneous Effects of Forward Guidance (November, 2019). International Finance Discussion Paper No. 1267, Available at SSRN: https://ssrn.com/abstract=3495344 or http://dx.doi.org/10.17016/IFDP.2019.1267

Francesco Ferrante (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
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United States

HOME PAGE: http://https://sites.google.com/site/franferrante/

Matthias O. Paustian

Board of Governors of the Federal Reserve System ( email )

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

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