DP7581 Limitations on the Effectiveness of Forward Guidance at the Zero Lower Bound

Author(s): Andrew Levin , J David López-Salido , Edward Nelson , Tack Yun

Publication Date: November 2009

Keyword(s): Forward Guidance , Optimal Policy under Commitment , Zero Lower Bound

JEL(s): E32 , E43 , E52

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP7581.asp

The recent literature on monetary policy in the presence of a zero lower bound on interest rates has shown that forward guidance regarding the path of interest rates can be very effective in preserving macroeconomic stability in the face of a contractionary demand shock; moreover, that literature apparently leaves little scope for any further improvements in stabilization performance via nontraditional monetary policies. In this paper, we characterize optimal policy under commitment in a prototypical New Keynesian model and examine whether those conclusions are sensitive to the specification of the shock process and to the interest elasticity of aggregate demand. Although forward guidance is effective in offsetting natural rate shocks of moderate size and persistence, we find that the macroeconomic outcomes are much less appealing for larger and more persistent shocks, especially when the interest elasticity parameter is set to values widely used in the literature. Thus, while forward guidance could be sufficient for mitigating the effects of a 'Great Moderation'-style shock, a combination of forward guidance and other monetary policy measures - such as large-scale asset purchases - might well be called for in responding to a 'Great Recession'-style shock.