The Power of Forward Guidance and the Fiscal Theory of the Price Level

Abstract

Standard New Keynesian models predict implausibly large and favorable responses of inflation and output to expansionary forward guidance on interest rates. We find that the introduction of permanent or recurring active fiscal policy dampens the response of output and inflation to forward guidance in the New Keynesian model. Moreover, the presence of regime-switching policy introduces expectation effects that cause forward guidance to be less stimulative in our regime-switching model's active money, passive fiscal policy regime. Finally, the introduction of long-term debt affects the magnitude of the stimulus resulting from forward guidance in models with active fiscal policy.

Imperfect Law Enforcement, Informality, and Organized Crime

“…This puzzle, discussed by Del Negro (2019)). McClung (2020) shows that a regime characterized by passive monetary policy and active fiscal policy does not imply forward guidance puzzle. With active fiscal policy, Ricardian equivalence does not hold and agents perceive government debt as net wealth.…”

Does My Model Predict a Forward Guidance Puzzle?

“…Moreover, the contemporaneous impact of such policies can be made arbitrarily large today simply by pushing the actual implementation of the policy farther into the future, a phenomenon known as the Forward Guidance Puzzle. Since this feature 1 of structural monetary models was first pointed out by papers such as Del Negro et al (2012) and Carlstrom et al (2015), a number of authors have sought to ameliorate and explain away this puzzle using, for example, credibility (Haberis et al, 2019), imperfect information (Carlstrom et al, 2015;Kiley, 2016), bounded rationality (Gabaix, 2016;Angeletos and Lian, 2018), life-cycle considerations (Del Negro et al, 2012;Eggertsson and Mehrotra, 2014;Eggertsson et al, 2019), heterogeneous agents with incomplete markets (McKay et al, 2016), or the fiscal theory of the price level (Cochrane, 2017;McClung, 2019) to name just a few.…”