Household Debt and the Heterogeneous Effects of Forward Guidance

Francesco Ferrante and Matthias Paustian
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Matthias Paustian: https://www.federalreserve.gov/econres/matthias-o-paustian.htm

No 1267, International Finance Discussion Papers from Board of Governors of the Federal Reserve System (U.S.)

Abstract: We develop an incomplete-markets heterogeneous agent New-Keynesian (HANK) model in which households are allowed to lend and borrow, subject to a borrowing constraint. We show that, in this framework, forward guidance, that is the promise by the central bank to lower future interest rates, can be a powerful policy tool, especially when the economy is in a liquidity trap. In our model, the power of forward guidance is amplified by three redistributive channels, absent in a representative agent new- Keynesian model (RANK) or in a HANK model without private debt. First, expected lower rates imply a future transfer of wealth from savers to borrowers, reducing precautionary motives and stimulating current demand and inflation. Second, higher initial inflation lowers the path of the real rate increasing the wealth of borrowers, who have a higher marginal propensity to consume (MPC). Third, if debt is nominal, debt deflation generates also a wealth transfer towards high-MPC borrowing-constrained agents, further increasing aggregate consumption and inflation. These channels amplify each other in a liquidity trap, and can make forward guidance more powerful in a HANK model than in a RANK framework. These results contrast with previous research on HANK models, which focused on frameworks where agents were not allowed to borrow, and which found negligible effects of forward guidance.

Keywords: HANK model; Zero lower bound; Forward guidance; Household debt (search for similar items in EconPapers)
JEL-codes: E21 E32 E52 E58 (search for similar items in EconPapers)
Pages: 35 pages
Date: 2019-11-27
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Citations: View citations in EconPapers (4)

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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgif:1267

DOI: 10.17016/IFDP.2019.1267

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