Disciplining Expectations and the Forward Guidance Puzzle

63 Pages Posted: 25 Jun 2020

See all articles by Tobias Fabian Müller

Tobias Fabian Müller

Boston College, College of Arts and Sciences, Department of Economics, Students

Kai Philipp Christoffel

European Central Bank (ECB)

Falk Mazelis

European Central Bank (ECB)

Carlos Montes-Galdon

European Central Bank

Date Written: June, 2020

Abstract

Forward guidance operates via the expectations formation process of the agents in the economy. In standard quantitative macroeconomic models, the expectations are unobserved state variables and little scrutiny is devoted to analysing the dynamic behaviour of these expectations. We show that the introduction of survey and financial market-based forecasts in the estimation of the model disciplines the expectations formation process in DSGE models. When the model-implied expectations are matched to observed expectations, the additional information of the forecasts restrains the agents’ expectations formation. We argue that the reduced volatility of the agents’ expectations dampens the model reactions to forward guidance shocks and improves the out-of-sample forecast accuracy of the model. Furthermore, we evaluate the case for introducing a discount factor as a reduced form proxy for a variety of microfounded approaches, proposed to mitigate the forward guidance puzzle. Once data on expectations is considered, the empirical support to introduce a discount factor dissipates.

Keywords: Bayesian estimation, DSGE models, expectations formation, forecasting, monetary policy

JEL Classification: C13, C52, E3, E47, E52

Suggested Citation

Müller, Tobias Fabian and Christoffel, Kai Philipp and Mazelis, Falk and Montes-Galdon, Carlos, Disciplining Expectations and the Forward Guidance Puzzle (June, 2020). ECB Working Paper No. 20202424, Available at SSRN: https://ssrn.com/abstract=3633829

Tobias Fabian Müller

Boston College, College of Arts and Sciences, Department of Economics, Students ( email )

MA
United States

Kai Philipp Christoffel (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Falk Mazelis

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Carlos Montes-Galdon

European Central Bank ( email )

Kaiserstrasse 29
D-60311 Frankfurt am Main
Germany

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