When Can Central Banks Credibly Provide Forward Guidance?

Lewis, Daniel [Browse]
Senior thesis
74 pages


Shin, Hyun Song [Browse]
Princeton University. Department of Economics [Browse]
Class year
Restrictions note
Walk-in Access. This thesis can only be viewed on computer terminals at the Mudd Manuscript Library.
Summary note
This paper examines the conditions under which central banks can credibly commit to forward guidance policies. Forward guidance is the practice of announcing a commitment to maintain interest rates at their lower bound during future periods when current-period interest rates cannot provide adequate stimulus due to reaching their lower bound. Previous papers characterize optimal forward guidance policies under conditions of perfect commitment but no existing work analyzes the degree to which such commitment may be possible; empirical studies have shown that commitment is imperfect. The scenario is represented as a non-cooperative game between the market and the central bank, where the market decides whether to accept or reject the central bank’s guidance promise based on rational expectations. Arguments in the central bank’s objective function are derived from the forward-looking New Keynesian model. Under single-period discretionary strategies, forward guidance is never credible. A threshold value for the central bank’s discount factor is obtained under which a sub-game perfect grim trigger equilibrium exists, corresponding to credible forward guidance. Central banks that focus more on inflation will find it harder to commit, as will those facing a steep Phillips curve. Economies exposed to higher-variance shocks are less likely to see effective forward guidance. The same is true for a high household discount factor, a high natural rate of interest, and a low inter-temporal elasticity of substitution. The model’s predictions are borne out reasonably well by case studies from the Great Recession.

Supplementary Information