Discussion paper

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

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.

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Citation

Coenen, G, C Montes-Galdón and F Smets (eds) (2021), “DP16050 Effects of State-Dependent Forward Guidance, Large-Scale Asset Purchases and Fiscal Stimulus in a Low-Interest-Rate Environment”, CEPR Press Discussion Paper No. 16050. https://cepr.org/publications/dp16050