Monetary-Fiscal Forward Guidance

Abstract

When central banks announce future interest rate cuts, the expected costs of servicing government debt decrease, freeing up additional resources in future budgets. This paper demonstrates that if the rational-expectations assumption is dropped, fiscal authority can exploit these savings by allocating them to future transfers. By announcing these transfers to households today, fiscal authorities can enhance the output effects of forward guidance. Employing a version of the New Keynesian setup with bounded rationality in the form of level-k thinking, I derive an analytical expression that captures the output effects of this additional fiscal announcement. A similar formula is then derived in a tractable heterogeneous agent New Keynesian model, incorporating bounded rationality, uninsured idiosyncratic risk, and targeted transfers. Finally, these analytical insights are used to investigate the effects of a forward-guidance-induced fiscal announcement in a fully-blown heterogeneous agent New Keynesian model with level-k thinking, calibrated to match U.S. data. The findings suggest that fiscal communication can amplify the output effects of standard one-year-ahaed forward guidance by 42%. Moreover, those gains can reach 85% when the debt-to-GDP ratio doubles. This indicates that forward guidance, when complemented by fiscal announcements regarding future transfers, can be an effective policy tool, particularly when both monetary and fiscal policies are constrained, such as during liquidity trap episodes accompanied by high levels of public debt.