Forward Guidance

We assess the power of forward guidance--promises about future interest rates--as a monetary tool in a liquidity trap using a quantitative incomplete-markets model. Our results suggest the effects of forward guidance are negligible. A commitment to keep future nominal interest rates low for a few quarters--although macro indicators suggest otherwise--has only trivial effects on current output and employment. We explain theoretically why in complete markets models forward guidance is powerful--generating a "forward guidance puzzle"--and why this puzzle disappears in our model. We also clarify theoretically ambiguous conclusions from previous research about the effectiveness of forward guidance in incomplete and complete markets models