Some solutions to the forward guidance puzzle
Stéphane Dupraz discusses the “forward guidance puzzle” in monetary policy and explores various solutions to address it. He first analyzes the baseline New Keynesian model and its implications for forward guidance and then he compares different model variations, including:
– Baseline New Keynesian model with rational expectations
– New Keynesian model with bounded rationality
– Semi-structural model (FR-BDF)
Dupraz examines several potential solutions to the forward guidance puzzle:
- Finite Lifespan: While this approach reduces the direct effects of future interest rates, it may not sufficiently mitigate the impact of forward guidance.
- Household Heterogeneity: Introducing precautionary savings and borrowing constraints does not necessarily diminish the impact of future interest rates on aggregate demand.
- Bounded Rationality: This approach appears to be the most promising solution. By assuming that firms and households have boundedly rational expectations while financial markets maintain rational expectations, the model can solve the forward guidance puzzle while accounting for the impact of monetary policy on asset prices.
- Imperfect Credibility: While this solution can reduce the weight of future rate announcements, it has limitations in capturing the strong response of asset prices to such announcements.
Model comparisons
- The baseline New Keynesian model with rational expectations shows an unrealistically large and diverging effect of forward guidance.
- The New Keynesian model with bounded rationality demonstrates a more realistic and non-diverging impact of forward guidance announcements.
- The semi-structural FR-BDF model, used by the Banque de France, also avoids the forward guidance puzzle and shows effects comparable to the bounded rationality model.
Conclusion
The study concludes that bounded rationality currently appears to be the most promising solution to the forward guidance puzzle. This approach allows for a more realistic representation of the effects of forward guidance while still capturing the impact of monetary policy on asset prices.
Evaluating monetary policies in the face of the “forward guidance puzzle”
Author: Stéphane Dupraz
From: Banque de France
Another solution to the forward guidance puzzle: lessons from the Great Depression
Gauti B. Eggertsson and Finn D. Schüle examine the forward guidance puzzle in New Keynesian models and argue that it is not actually a puzzle when properly understood. More specifically, the authors analyze a textbook New Keynesian model and demonstrate how the forward guidance puzzle emerges “if the central bank commits to remain unresponsive to inflation and output dynamics between the announcement of future policy cuts and their implementation.” They then calibrate the model to match historical data from the Great Depression era and compare the model’s predictions to actual output and inflation data during four regime change episodes.
Key findings:
- The forward guidance puzzle stems from an implausible assumption about monetary policy regimes, not an inherent flaw in the New Keynesian model.
- The puzzle disappears when the central bank is allowed to respond to economic developments between announcing and implementing future interest rate changes.
- Even at the zero lower bound (ZLB), it requires a major regime change in monetary policy to generate the explosive dynamics associated with the puzzle.
- When calibrated to four significant regime changes during the U.S. Great Depression, the model’s predictions align well with historical data. The authors identify these regime changes as:
– Roosevelt’s 1933 abandonment of the gold standard and commitment to reflate prices
– Eccles’ 1934 appointment as Federal Reserve Chair
– The “mistake of 1937” when monetary policy was prematurely tightened
– The 1938 policy reversal recommitting to reflation - Changes in the expected duration of the ZLB, inferred from movements in long-term interest rates, can rationalize the observed data on output and inflation during these episodes.
- The authors conclude that when evaluating forward guidance, the key aspect is whether it implies a fundamentally new policy regime different from the existing one.
Conclusion
In essence, the authors argue that the forward guidance puzzle is not a puzzle at all, but rather a result of unrealistic assumptions about monetary policy regimes. When more plausible regime changes are considered, the New Keynesian model’s predictions align well with historical evidence from the Great Depression era.
The Forward Guidance Puzzle is not a Puzzle
Authors: Gauti B. Eggertsson, Finn D. Schüle
From: Brown University
