The interaction of forward guidance in a two-country new Keynesian model

Abstract

Using the method of Haberis and Lipi ńska (2020), this paper explores the effect of forward guidance (FG) in a two-country New Keynesian (NK) economy under the zero lower bound (ZLB). We simulate the effect of different length of FG or the zero interest rate policy under the circumstance of the global liquidity trap. We show that the size of the intertemporal elasticity of substitution plays an important role in determining the beggar-thy-neighbor effect or the prosperthy-neighbor effect of home FG policy on the foreign economy. And in the former case, by targeting a minimum welfare loss of the individual country alone but not global welfare loss, two central banks can perform interesting FG bargaining in which they cooperatively adopt the same length of FG or strategically deviate from cooperation.