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Forward Guidance under Imperfect Information: Instrument Based or State Contingent?

Chengcheng Jia ()

No 201922, Working Papers from Federal Reserve Bank of Cleveland

Abstract: I study the optimal type of forward guidance in a flexible-price economy in which both the private sector and the central bank are subject to imperfect information about the aggregate state of the economy. In this case, forward guidance changes the private sector?s expectations about both future monetary policy and the state of the economy. I study two types of forward guidance. The first type is instrument based, in which case the central bank commits to a value of the policy instrument. The second type is state contingent, in which case the central bank reveals its imperfect information and commits to a policy response rule. The key message is that forward guidance allows the central bank to reduce ex-ante price fluctuations by making the optimal trade-off between price deviations after the actual shock and after the noise shock. However, this benefit comes with a cost under the instrument-based forward guidance; that is, since firms perfectly know the change in monetary policy and prices are fully flexible, the real output level becomes independent of monetary policy. Consequently, while state-contingent forward guidance guarantees ex-ante welfare improvement, instrument-based forward guidance improves ex-ante welfare only if the central bank?s information is sufficiently precise.

JEL-codes: D82 D83 E52 E58 (search for similar items in EconPapers)
Pages: 49 pages
Date: 2019-11-05
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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DOI: 10.26509/frbc-wp-201922

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