Munich Personal RePEc Archive

Monetary-Fiscal Forward Guidance

Kopiec, Paweł (2024): Monetary-Fiscal Forward Guidance.

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When central banks announce cuts to future interest rates, the expected costs of government debt service decrease, generating additional resources in future budgets. This paper demonstrates that if the rational-expectations assumption is dropped, fiscal authority can exploit those gains by spending them on future transfers and, by announcing those transfers to households today, can enhance the output effects of forward guidance. Employing a version of the New Keynesian setup featuring bounded rationality in the form of level-k thinking, I derive an analytical expression capturing the output effects of that additional fiscal announcement. Subsequently, a similar formula is derived in a tractable heterogeneous agent New Keynesian model with bounded rationality, uninsured idiosyncratic risk, and redistributive effects of transfers. Finally, I use these analytical insights to explore the effects of the forward-guidance-induced fiscal announcement in a fully-blown heterogeneous agent New Keynesian framework with level-k thinking calibrated to match US data. The findings suggest that fiscal communication can amplify the output effects of standard forward guidance by 66%. Moreover, those gains can reach 120% when the debt-to-GDP ratio doubles. This suggests that forward guidance enriched with fiscal announcements about future transfers can be considered an effective policy option when both monetary and fiscal policies are constrained, e.g., during liquidity trap episodes accompanied by high levels of public debt.

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