September 2020 issue contents
The Limits of Central Bank forward Guidance under Learning

Stephen J. Cole
Marquette University


This paper investigates the effectiveness of central bank forward guidance while relaxing two standard macroeconomic assumptions: rational expectations and frictionless financial markets. The results show that the addition of financial frictions amplifies the differences between rational expectations and adaptive learning to forward guidance. During a period of economic crisis, output under rational expectations displays more favorable responses to forward guidance than under adaptive learning. These differences are exacerbated when compared with a similar analysis without financial frictions. Thus, monetary policymakers should consider the way in which expectations and credit frictions are modeled when examining the effects of forward guidance.

JEL Code: D84, E30, E44, E50, E52, E58, E60.

Full article (PDF, 52 pages, 1190 kb)