Forward Guidance and Credible Monetary Policy

The effectiveness of forward guidance depends on the credibility of the central bank. This paper sheds light on the credible forward guidance that a central bank can offer by solving for the whole set of sustainable sequential equilibrium (SSE) in a canonical New Keynesian model with occasionally binding zero lower bound (ZLB). The best credible forward guidance provides a better account of the Fed's policy practice than those under Ramsey equilibrium and Markov perfect equilibrium, including less aggressiveness in entering the ZLB, much longer duration at low or zero rates, and finally smooth and gradual exit. Quantitative results show that the Ramsey equilibrium is not generally implementable. However, central banks with credibility can boost consumption in recessions close to the degree of that provided by a commitment central bank