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The Limits of Central Bank Forward Guidance under Learning

Stephen Cole ()

No 2016-02, Working Papers and Research from Marquette University, Center for Global and Economic Studies and Department of Economics

Abstract: Central bank forward guidance emerged as a pertinent tool for monetary policymakers since the Great Recession. Nevertheless, the effects of forward guidance remain unclear. This paper investigates the effectiveness of forward guidance while relaxing two standard macroeconomic assumptions: rational expectations and frictionless financial markets. Agents forecast future macroeconomic variables via either the rational expectations hypothesis or a more plausible theory of expectations formation called adaptive learning. A standard Dynamic Stochastic General Equilibrium (DSGE) model is extended to include the financial accelerator mechanism. The results show that the addition of financial frictions amplifies the differences between rational expectations and adaptive learning to forward guidance. The macroeconomic variables are overall more responsive to forward guidance under rational expectations than under adaptive learning. During a period of economic crisis (e.g. a recession), output under rational expectations displays more favorable responses to forward guidance than under adaptive learning. These differences are exacerbated when compared to a similar analysis without financial frictions. Thus, monetary policymakers should consider the way in which expectations and credit frictions are modeled when examining the effects of forward guidance.

Keywords: Forward Guidance; Monetary Policy; Adaptive Learning; Expectations; Financial Frictions (search for similar items in EconPapers)
JEL-codes: D84 E30 E44 E50 E52 E58 E60 (search for similar items in EconPapers)
Date: 2016-03
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
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http://epublications.marquette.edu/econ_workingpapers/52 (application/pdf)

Related works:
Journal Article: The Limits of Central Bank forward Guidance under Learning (2020) Downloads
Working Paper: The limits of central bank forward guidance under learning (2016) Downloads
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