Forward Guidance

The paper assesses the power of forward guidance—promises about future interest rates—as a monetary tool in a liquidity trap using a quantitative incomplete-markets model. The results suggest the effects of forward guidance are negligible. A commitment to keep future nominal interest rates low for a few quarters—although macro indicators suggest otherwise—has only trivial effects on current output and employment. The paper explains theoretically why in complete markets models forward guidance is powerful—generating a “forward guidance puzzle”—and why this puzzle disappears in our model. It also clarifies theoretically ambiguous conclusions from previous research about the effectiveness of forward guidance in incomplete and complete markets models.