Optimal monetary policy in a low interest rates environment

Abstract

This thesis explores forward guidance as a critical tool in modern monetary policy, particularly in addressing economic crises when traditional tools are constrained by the zero lower bound (ZLB). It examines its theoretical underpinnings, practical applications, and evolution, empha- sizing its role during periods of crisis such as the COVID-19 pandemic. The study is grounded in Michael Woodford’s framework for optimal monetary policy, focusing on price stability, out- put gap minimization, and managing expectations. These principles highlight the necessity of unconventional strategies, such as forward guidance and quantitative easing, to counteract defla- tion and stimulate demand in low-interest-rate environments. Forward guidance is analyzed in two forms: Delphic, which offers forecast-based transparency, and Odyssean, which ties future actions to specific economic conditions, thereby enhancing credibility. Using case studies from the COVID-19 pandemic, the thesis demonstrates how central banks, including the Federal Reserve and the European Central Bank, employed forward guidance to stabilize markets, anchor inflation expectations, and support recovery. The transition from Delphic to Odyssean guidance during crisis reflects its adaptability to dynamic economic conditions. The results indicate that forward guidance effectively shapes market expectations, promotes stability, and complements other mon- etary policies. However, its success depends on credible communication, clear objectives, and the ability to address challenges such as myopic expectations and uneven recoveries.