Term structure and forward guidance as instruments

Authors: Michael Magill Martine Quinzii

Publish Date: 2013/09/11

Volume: 56, Issue: 1, Pages: 1-32

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Abstract

This paper studies a simple monetary model with a Ricardian fiscal policy in which equilibria are indeterminate if monetary policy consists solely of a rule for fixing the shortterm interest rate We introduce explicitly into the model the agents’ expectations of inflation which create the indeterminacy and show that there are two types of policies—a term structure rule or a forward guidance rule for the short rate—which lead to determinacy The first consists in fixing the interest rates on a family of bonds of different maturities as function of realized inflation the second consists in fixing the shortterm interest rate and the expected values of the shortterm interest rate for a sequence of periods into the future as a function of realized inflation If the monetary authority chooses an inflation process that satisfies conditions derived in the paper and applies one of these rules it anchors agents’ expectations to this process in the sense that it is the unique inflation process compatible with equilibrium when the interest rates or expected future values of the short rate are those specified by the term structure or forward guidance ruleThis paper has circulated under the title “Interest Rate Policy and Expectations of Inflation” We are grateful to Tiago Berrial Alex Citanna Marvin Goodfriend Yong Kim Bennett McCallum Ricardo Reis Paolo Siconolfi Guillaume Vandenbroucke Carl Walsh and Michael Woodford for helpful discussions and to participants in seminars at Carnegie Mellon University Columbia University University of California Santa Cruz University of Southern California and the EPGE at the Getulio Vargas Foundation for helpful comments

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