DP11251 Optimal Forward Guidance

Author(s): Florin Ovidiu Bilbiie
Publication Date: April 2016
Date Revised: July 2017
Keyword(s): delphic, forward guidance, heterogenous agents, heterogenous beliefs, liquidity trap, odyssean, Ramsey optimal monetary policy, zero lower bound
JEL(s): E21, E31, E40, E50
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11251

Optimal forward guidance (OFG) is the simple policy of keeping interest rates low for some time after the liquidity trap, moving straight to normal-times optimal policy thereafter, and determining the extra accommodation duration optimally. I solve for the optimal duration in closed form in a new-Keynesian model, where OFG is close to fully-optimal Ramsey. The simple rule "announce a duration of half of the trap?s duration times the disruption" is a good approximation and alleviates credibility problems. Because it anchors expectations of (delphic) agents who otherwise mistake commitment for bad news, the simple rule is often welfare-preferable to odyssean commitment.