DP11251 Optimal Forward Guidance
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.