Endogenous forward guidance
Working Paper N° 354
We propose a novel framework where forward guidance (FG) is endogenously determined.
Our model assumes that a monetary authority solves an optimal policy problem under com-
mitment at the zero-lower bound. FG derives from two sources: 1. from commiting to keep
interest rates low at the exit of the liquidity trap, to stabilize inﬂation today. 2. From debt
sustainability concerns, when the planner takes into account the consolidated budget constraint in optimization. Our model is tractable and admits an analytical solution for interest rates in which 1 and 2 show up as separate arguments that enter additively to the standard Taylor rule.
In the case where optimal policy reﬂects debt sustainability concerns (satisﬁes the consoli-
dated budget) monetary policy becomes subservient to ﬁscal policy, giving rise to more volatile
inﬂation, output and interest rates. Liquidity trap (LT) episodes are longer, however, the impact
of interest rate policy commitments on inﬂation and output are moderate. ’Keeping interest
rates low’ for a long period, does not result in positive inﬂation rates during the LT, in contrast
our model consistently predicts negative inﬂation at the onset of a LT episode.
In contrast, in the absence of debt concerns, LT episodes are shorter, but the impact of
commitments to keep interest rates low at the exit from the LT, on inﬂation and output is
substantial. In this case monetary policy accomplishes to turn inﬂation positive at the onset of
the episode, through promising higher inﬂation rates in future periods.
We embed our theory into a DSGE model and estimate it with US data. Our ﬁndings suggest
that FG during the Great Recession may have partly reﬂected debt sustainability concerns, but
more likely policy reﬂected a strong commitment to stabilize inﬂation and the output gap.
Our quantitative ﬁndings are thus broadly consistent with the view that the evolution of debt
aggregates may have had an impact on monetary policy in the Great Recession, but this impact is likely to be small.