The Stimulative Effect of Forward Guidance

Posted: 26 Dec 2013

See all articles by William T. Gavin

William T. Gavin

Federal Reserve Bank of St. Louis - Research Division; University of Memphis Department of Economics

Benjamin D. Keen

affiliation not provided to SSRN

Alexander W. Richter

Federal Reserve Bank of Dallas

Nathaniel A. Throckmorton

William & Mary

Date Written: 2013

Abstract

This paper examines the stimulative effect of central bank forward guidance?the promise to keep future policy rates lower than its policy rule suggests?when the short-term nominal interest rate is stuck at its zero lower bound (ZLB).We utilize a standard New Keynesian model in which forward guidance enters our model as news shocks to the monetary policy rule. Three key findings emerge: (1) Forward guidance is more stimulative at the ZLB when households believe the economic recovery will be strong. When households expect a weak recovery or initially have low confidence in the economy, forward guidance is less stimulative because interest rates are already expected to remain low; (2) Longer forward guidance horizons do not cause the stimulative effect to explode or reverse, but rather spread the effect across the entire horizon; and (3) Failing to include a ZLB constraint causes the model to substantially overstate the stimulative effect of forward guidance. Given those findings, we use Blue Chip survey data to compare our model?s predictions of the stimulative effect of forward guidance to data before and after the Fed?s historic policy announcement on August 9, 2011. The results in that case study provide an explanation for the Forward Guidance Puzzle?the claim that New Keynesian models overestimate the effect of forward guidance.

Keywords: Monetary Policy, Forward Guidance, Zero Lower Bound, Global Solution Method

JEL Classification: E43, E47, E53, E58

Suggested Citation

Gavin, William T. and Keen, Benjamin D. and Richter, Alexander W. and Throckmorton, Nathaniel A., The Stimulative Effect of Forward Guidance (2013). FRB St. Louis Working Paper No. 2013-38, Available at SSRN: https://ssrn.com/abstract=3946811

William T. Gavin (Contact Author)

Federal Reserve Bank of St. Louis - Research Division ( email )

441 Locust Street
P. O. Box 442
St. Louis, MO 63166
United States
314 873-8422 (Phone)

HOME PAGE: http://www.gavinecon.com

University of Memphis Department of Economics ( email )

Memphis, TN 38152
United States

Benjamin D. Keen

affiliation not provided to SSRN ( email )

No Address Available

Alexander W. Richter

Federal Reserve Bank of Dallas ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States
214-922-5360 (Phone)

HOME PAGE: http://alexrichterecon.com

Nathaniel A. Throckmorton

William & Mary ( email )

Economics Department
P.O. Box 8795
Williamsburg, VA 23187
United States

HOME PAGE: http://nathrockmorton.people.wm.edu/

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