Forward guidance and the role of central bank credibility under heterogeneous beliefs

Abstract

This paper studies the macroeconomic effects of central bank forward guidance when central bank credibility is endogenous. We take a stylized New Keynesian model with an occasionally binding effective lower bound constraint on nominal interest rates and heterogeneous and boundedly rational households. Central bank forecasts follow a bivariate VAR, not taking into account the time-variation in the distribution of aggregate expectations. In this framework, we extend the central bank’s toolkit to allow for the publication of its own forecasts (Delphic guidance) and the commitment to a future path of the nominal interest rate (Odyssean guidance). We find that both Delphic and Odyssean forward guidance increase the likelihood of recovery from a liquidity trap. Even though Odyssean guidance alone appears more powerful in inducing recovery, we find it to increase ex post macroeconomic volatility and thus reduce welfare.