DP16050 Effects of State-Dependent Forward Guidance, Large-Scale Asset Purchases and Fiscal Stimulus in a Low-Interest-Rate Environment

Author(s): Günter Coenen, Carlos Montes-Galdon, Frank Smets
Publication Date: April 2021
Keyword(s): asset purchases, effective lower bound, Euro Area, Fiscal policy, forward guidance, monetary policy
JEL(s): E31, E32, E37, E52, E62
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16050

We study the incidence and severity of periods with a binding effective lower bound on nominal interest rates and the efficacy of three types of state-dependent policies-forward guidance about the path of future interest rates, large-scale asset purchases and spending based fiscal stimulus-in mitigating the detrimental consequences of the lower bound. Based on the ECB's New Area-Wide Model of the euro area, our findings suggest that, if unaddressed, the lower bound can cause substantial macroeconomic distortions. In the near term, forward guidance, if fully credible, is most powerful and can largely undo the distortions due to the lower bound. A combination of imperfectly credible forward guidance, asset purchases and fiscal stimulus is almost equally effective, especially when asset purchases enhance the credibility of the forward-guidance policy via a signalling effect. In the long run, with an equilibrium real rate as low as zero, a combination of all three policies is needed to materially reduce the distortions.