Learning and the effectiveness of central bank forward guidance
Stephen Cole ()
MPRA Paper from University Library of Munich, Germany
The unconventional monetary policy of forward guidance operates through the management of expectations about future paths of interest rates. This paper examines the link between expectations formation and the effectiveness of forward guidance. A standard New Keynesian model is extended to include forward guidance shocks in the monetary policy rule. Agents form expectations about future macroeconomic variables via either the standard rational expectations hypothesis or a more plausible theory of expectations formation called adaptive learning. The results show the efficacy of forward guidance depends on the manner in which agents form their expectations. In response to forward guidance, the paths of the output gap and inflation under adaptive learning overshoot and undershoot those implied by rational expectations. The adaptive learning impulse responses of the endogenous variables to a forward guidance shock exhibit more persistence before and after the forward guidance shock has been realized upon the economy. During an economic crisis (e.g. a recession), the assumption of rational expectations overstates the effects of forward guidance relative to adaptive learning. Specifically, the output gap is higher under rational expectations than adaptive learning. Thus, if monetary policy is based on a model with rational expectations, which is the standard assumption in the macroeconomic literature, the results of forward guidance could be potentially misleading.
Keywords: Forward Guidance; Monetary Policy; Adaptive Learning; Expectations (search for similar items in EconPapers)
JEL-codes: D84 E30 E50 E52 E58 E60 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
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Journal Article: Learning and the Effectiveness of Central Bank Forward Guidance (2021)
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Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:65207
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