How to Model Forward Guidance and Address a Larger Puzzle

46 Pages Posted: 10 Jun 2020 Last revised: 1 Jul 2021

See all articles by Derin Aksit

Derin Aksit

Johns Hopkins University - Department of Economics

Date Written: April 17, 2020

Abstract

Forward guidance during the zero lower bound period is typically modeled as news that alters the expected liftoff date of the policy rate, assuming that agents do not expect a policy rate hike in near future. Using U.S. high-frequency data, I empirically reject this assumption and show that forward guidance affects the entire term structure of expected rates. Introducing this estimated forward guidance shock in a standard New Keynesian model substantially magnifies the "forward guidance puzzle", i.e. the excessive model-implied response to forward guidance. I show that allowing agents to update their macroeconomic expectations in the pessimistic direction following a forward guidance easing explains this larger puzzle per se, unlike the common approach of introducing a discount parameter due to a deviation from a baseline assumption. In addition, I find that the puzzle can also be explained by sticky information general equilibrium models.

Keywords: Forward Guidance, Impulse Response Matching, DSGE models, Expectations

JEL Classification: E52, E32, E44

Suggested Citation

Aksit, Derin, How to Model Forward Guidance and Address a Larger Puzzle (April 17, 2020). Available at SSRN: https://ssrn.com/abstract=3602211 or http://dx.doi.org/10.2139/ssrn.3602211

Derin Aksit (Contact Author)

Johns Hopkins University - Department of Economics ( email )

3400 Charles Street
Baltimore, MD 21218-2685
United States

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