Forward Guidance in the Nonlinear New Keynesian Model

Elena Perazzi

MPRA Paper from University Library of Munich, Germany

Abstract: The forward-guidance puzzle refers to the implausibly large effects of anticipated future interest rate changes on current output and inflation, as predicted by standard New Keynesian models. In this paper, we analyze both theoretically and numerically the nonlinear model that underlies the canonical linearized framework, explicitly tracking the full distribution of prices across firms. We show that large output expansions arise only under extreme and economically implausible circumstances: firms that are unable to reset prices are forced to sell below marginal cost while satisfying unbounded demand, thereby accumulating arbitrarily large losses. When we modify the model so that non-reoptimizing firms can at least set prices equal to marginal cost, output and inflation remain bounded and moderate. However, under this modification not all forward-guidance announcements are feasible in equilibrium. Our results identify a neglected microeconomic assumption as the root cause of the forward-guidance puzzle and clarify the limits of New Keynesian models in the analysis of large or persistent monetary shocks.

Keywords: Forward Guidance; Nonlinear New Keynesian model; Equilibrium Feasibility (search for similar items in EconPapers)
JEL-codes: E4 E5 E6 (search for similar items in EconPapers)
Date: 2026-02-09
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