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Research question Interest rate forward guidance has become an important monetary policy tool in recent years. However, traditional representative agent New Keynesian models tend to grossly overestimate the impact of forward guidance on the economy due to strong intertemporal substitution. With heterogeneous households, intertemporal substitution can be reduced. Hence, we quantify to what extent hand-to-mouth households can help to mitigate the power of forward guidance compared to a representative agent model. Contribution We build a medium-scale two-agent New Keynesian model featuring Ricardian and hand-to mouth households. The model includes a banking sector and is estimated on eight euro area time series. We analyze the quantitative importance of hand-to-mouth households to dampen the power of forward guidance relative to a representative agent model. In addition, we illustrate an interaction of forward guidance with asset purchases, as observed in recent years. Results We obtain three main results. (i) The power of forward guidance is attenuated, if there is an empirically realistic countercyclical redistribution across Ricardian and hand-to-mouth households. There are two opposing effects regarding the power of forward guidance when the economy features hand-to-mouth households. First, the aggregate intertemporal substitution is lower, as hand-tomouth households do not smooth consumption over time (direct effect). Second, the aggregate marginal propensity to consume is higher, since hand-to-mouth households spend all their income (indirect effect). Due to redistribution across households, the direct effect outweighs the indirect one. (ii) We quantify the conditions under which either the direct or indirect effect dominates. With no redistribution, the impact of forward guidance is indeed amplified. (iii) The interaction of forward guidance with asset purchases gives rise to non-linear effects that depend on the horizon of forward guidance.

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