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We study the welfare effects of international monetary policy spillovers at the zero lower bound, focusing on the effects of forward guidance in a large economy (“foreign”) on its smaller trading partner (“home”) in scenarios motivated by the global financial crisis. We find that foreign forward guidance has an overall prosper‐thy‐neighbor effect on the home economy as long as it increases foreign welfare. This finding holds under alternative assumptions about exchange rate pass‐through or the degree of international financial integration. However, foreign forward guidance may worsen the trade‐off between the stabilization objectives of home monetary policy.

We develop a general method for analyzing the effects of macroeconomic policy promises about which the private sector is uncertain. We illustrate the method in two applications to a central bank’s ‘forward guidance’ about the path for its policy rate. We demonstrate that uncertainty about forward guidance resulting from its potential to be imperfectly credible makes it much less powerful than in textbook models. In an application to the FOMC’s ‘threshold-based’ guidance, we show that increasing the precision of the conditions under which the policy rate ‘lifts off’ from the zero bound requires a lower unemployment threshold to deliver a given amount of stimulus.

We explore the effects of forward guidance at the zero lower bound when there is uncertainty over the lift-off date arising from: (i) the imperfect credibility of time-inconsistent forward-guidance promises; (ii) incomplete communication. We use a simple New Keynesian model to demonstrate that a forward guidance announcement to delay lift-off may be no more powerful in a more interest rate sensitive economy. We also demonstrate that attempts to delay lift-off further may fail to generate additional stimulus if the temptation to renege on the announcement is sufficiently great. In an empirical application, we consider counterfactual policy experiments based on the Federal Open Market Committee’s ‘threshold-based’ forward guidance, in which we link the probability of lift-off to the amount by which the announced unemployment threshold is breached. We show that a more precise articulation of the lift-off conditions requires a lower unemployment threshold in order to deliver the same amount of stimulus as a less precise one.

In this paper, we use an estimated DSGE model of the UK economy to investigate perceptions of the effectiveness of monetary policy since the onset of the 2007–08 financial crisis in a number of measures of deflation probability — the Survey of Economic Forecasts, financial-market option prices, and the Bank of England's Monetary Policy Committee’s (MPC) forecasts. To do so, we use stochastic simulations of the model to generate measures of deflation probability in which the effectiveness of monetary policy to offset deflationary shocks is affected by different assumptions about the existence and level of a lower bound on policy rates. We find that measures of deflation probability are consistent with the perception that the MPC was not particularly constrained in its ability to offset deflation shocks in the post-crisis period.

In this paper we describe a procedure for implementing zero restrictions within the context of a sign restrictions identification scheme for VARs. The procedure introduces an additional step into the algorithm outlined in Fry and Pagan (2011) and Rubio-Ramirez et al (2006) for implementing sign restrictions. This extra step involves rotating a candidate identification matrix using Givens rotation matrices to introduce zero restrictions. We then check whether the elements of the candidate matrix satisfy the sign restrictions as usual. We illustrate how our procedure works by generating artificial data from the theoretical model of An and Schorfheide (2007), which implies certain restrictions on the impact of its structural shocks on the model's endogenous variables. We exploit our knowledge of that pattern to identify structural shocks from the reduced-form errors of a VAR estimated on the simulated data. Imposing zero restrictions, as well as sign restrictions, can be useful – and in some cases essential – for identifying economically-interpretable – `structural' – shocks from the reduced-form innovations to a VAR. This is because it is often the case that an economic theory used to motivate these identifying restrictions implies certain variables do not respond at all to some shocks. For example, in the An and Schorfheide (2007) model we consider, shocks to government spending have no effect on inflation or the nominal interest rate – i.e. the impulse response is zero. Therefore, to obtain accurate, empirical estimates of the government spending shock in this model using a structural VAR estimated on data for its observable variables, it would be necessary to impose a zero restriction on the response of inflation and the nominal interest rate to the shock identified with government spending.

In this paper we describe a procedure for implementing zero restrictions within the context of a sign restrictions identification scheme for VARs. The procedure introduces an additional step into the algorithm outlined in Fry and Pagan (2011) and Rubio-Ramirez et al. (2006) for implementing sign restrictions. This extra step involves rotating a candidate identification matrix using Givens rotation matrices to introduce zero restrictions. We then check whether the elements of the candidate matrix satisfy the sign restrictions as usual. We illustrate how our procedure works by generating artificial data from the theoretical model of An and Schorfheide (2007), which implies certain restrictions on the impact of its structural shocks on the model's endogenous variables. We exploit our knowledge of that pattern to identify structural shocks from the reduced-form errors of a VAR estimated on the simulated data.

In this paper, we consider how monetary policy in a large, foreign economy affects optimal monetary policy in a small open economy (`home') in response to a large global demand shock that pushes both economies to the zero lower bound (ZLB) on nominal interest rates. We show that the inability of foreign monetary policy to stabilise the foreign economy at the ZLB creates a spillover that affects how well the home policymaker is able to stabilise its own economy. We show that more stimulatory foreign policy worsens the home policymaker's trade-off between stabilising inflation and the output gap when home and foreign goods are close substitutes. This reflects the fact that looser foreign policy leads to a relatively more appreciated home real exchange rate, which induces large expenditure switching away from home goods when goods are highly substitutable--just at a time (at the ZLB) when home policy is trying to boost demand for home goods. When goods are not close substitutes, the home policymaker's ability to stabilise the economy benefits from more stimulatory foreign policy.

This paper considers the implications for the United States, the United Kingdom and the rest of the world (ROW) of shocks that may contribute to a further reduction in global current account imbalances using a dynamic stochastic general equilibrium (DSGE) model. We consider a shock that increases domestic demand in the ROW; a shock that reduces domestic demand in the United States; and a supply shock that raises US productivity relative to other countries. The impact on UK output and inflation depends on the nature of the shock that drives global rebalancing. An increase in domestic demand in the ROW would raise UK exports and output, but would also contribute to increased inflationary pressure in the United Kingdom. Further weakness in US domestic demand is likely to weigh on UK output and inflation. Productivity gains in the United States relative to other countries would worsen the United Kingdom’s current account position, pushing down on output, but would lead to reduced inflationary pressure in the United Kingdom.