Answer to Question #191249 in Macroeconomics for James

Question

What is the difference between forward guidance and time consistency? Why are they important?

Answer 1

Forward guidance refers to the communication from a central bank about the state of the economy and likely future course of monetary policy while time consistency refers to when you make a commitment to take an action in the future. If the incentive to keep the commitment is the same as the incentive to make the commitment, it's time consistent. But if the incentive to keep it is significantly less than the incentive to make it, it's time inconsistent

When the foward guidance is a policy commitment, citizens understand that there is a possibility that the future economy will recover faster but the future policy rate is pegged at zero due to the Fed's policy commitment. In this case, the foward guidance increases their expectations of future output growth and inflation.