DP13383 Taylor Rules and Forward Guidance: A Rule is not a Path

Author(s): Lilia Maliar, John B. Taylor
Publication Date: December 2018
Date Revised: July 2020
Keyword(s): forward guidance, New Keynesian Model
JEL(s): C61, C63, C68, E31, E52
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13383

We study the impact of forward guidance--non-systematic announcements about future policy rates -- in a stylized new Keynesian model. Using novel closed-form solutions, we show that the impact of forward guidance depends critically on the systematic monetary policy rule, ranging from non-existing to unrealistically large, the so-called forward guidance puzzle. We demonstrate that the puzzle occurs only under relatively passive -- empirically implausible and socially suboptimal -- policy rules, while more active empirically-relevant Taylor rules lead to sensible implications. Our analysis encompasses the case of a fixed interest-rate path, which characterizes effective lower-bound (ELB) periods. We conclude that it is not ELB per se that produces backward explosion but the passivity of monetary policy rules.