Forward guidance with unanchored expectations

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Title: Forward guidance with unanchored expectations
Author: Eusepi, Stefano ; Gibbs, Chris ; Preston, Bruce
Organization: Bank of Finland
Series: Bank of Finland Research Discussion Papers
Series number: 11/2021
Year of publication: 2021
Publication date: 31.8.2021
Pages: 53
Subject (yso): rahapolitiikka; korko; odotukset; oppiminen; ekonometriset mallit
JEL: E32; D83; D84
Other keywords: Optimal Monetary Policy; Learning Dynamics; Expectations Stabilization; Forward Guidance
Abstract: We study zero interest-rate policy in response to a large negative demand shock when long-run expectations can fall over time. Because falling expectations make monetary policy less effective by raising real interest rates, the optimal forward guidance policy makes large front-loaded promises to stabilize expectations. Policy is too stimulatory in the event of transitory shocks, but provides insurance against persistent shocks. The optimal policy is well-approximated by a constant calendar-based forward guidance, independent of the shock’s realised persistence. The insurance property distinguishes our paper from other bounded rationality papers that solve the forward guidance puzzle and generates important quantitative differences.

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