The Effect of Central Bank Credibility on Forward Guidance in an Estimated New Keynesian Model

64 Pages Posted: 1 Jan 2020

See all articles by Stephen J. Cole

Stephen J. Cole

Marquette University

Enrique Martínez-García

Federal Reserve Bank of Dallas - Research Department

Multiple version iconThere are 3 versions of this paper

Date Written: November 27, 2019

Abstract

This paper examines the effectiveness of forward guidance in an estimated New Keynesian model with imperfect central bank credibility. Forward guidance and the credibility of the central bank are uniquely modeled by utilizing a game-theoretic evolutionary framework. We estimate credibility for the U.S. Federal Reserve with Bayesian methods exploiting survey data on interest rate expectations from the Survey of Professional Forecasters (SPF). The results provide important takeaways: (1) The estimate of Federal Reserve credibility in terms of forward guidance announcements is relatively high, which indicates a degree of forward guidance effectiveness, but still one that is below the fully credible case. (2) If a central bank is perceived as less credible, anticipation effects are attenuated and, accordingly, output and inflation do not respond as favorably to forward guidance announcements. (3) Imperfect credibility and forward guidance are an important aspect to resolve the so-called "forward guidance puzzle," which the literature shows arises from the unrealistically large responses of macroeconomic variables to forward guidance statements in structural models with perfect credibility. (4) Imperfect central bank credibility can also explain the evidence of forecasting error predictability based on forecasting disagreement found in the SPF data. Thus, accounting for imperfect credibility is important to model the formation of expectations in the economy and to understand the transmission mechanism of forward guidance announcements.

Keywords: Forward Guidance, Monetary Policy, Expectations, Central Bank Credibility, Evolutionary Games

JEL Classification: D84, E30, E50, E52, E58, E60

Suggested Citation

Cole, Stephen J. and Martinez-Garcia, Enrique, The Effect of Central Bank Credibility on Forward Guidance in an Estimated New Keynesian Model (November 27, 2019). Available at SSRN: https://ssrn.com/abstract=3495757 or http://dx.doi.org/10.2139/ssrn.3495757

Stephen J. Cole (Contact Author)

Marquette University ( email )

P.O. Box 1881
Milwaukee, WI 53201-1881
United States

Enrique Martinez-Garcia

Federal Reserve Bank of Dallas - Research Department ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States
214-922-5262 (Phone)

HOME PAGE: http://sites.google.com/view/emgeconomics

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