Posted Friday, Aug. 31, 2012, at 2:41 PM
Columbia University's Michael Woodford did a paper for the Jackson Hole conference where he lays out the case (PDF) for an NGDP targeting approach to monetary policy. One piece of it I liked was this brief summary of why forward guidance matters a lot when interest rates are at the zero bound:
Standard New Keynesian models imply that a higher level of expected real income or inflation in the future creates incentives for greater real expenditure and larger price increases now but in the case of a conventional interest-rate reaction function for the central bank, short-term interest rates should increase, and the disincentive that this provides to current expenditure will attenuate (without completely eliminating) the sensitivity of current conditions to expectations. If nominal interest rates instead remain unchanged, the degree to which higher expected real income and inflation later produce higher real income and inflation now is amplified. If the situation is expected to persist for a period of time, the degree of amplification should increase exponentially. Hence it is precisely when the interest-rate lower bound is expected to be a binding constraint for some time to come that expectations about the conduct of policy after the constraint ceases to bind should have a particularly large effect on current economic conditions — to the extent, that is, that it is possible to shift expectations about conditions that far in the future.
To try to translate that into an example, you're considering borrowing some money to build a big apartment complex. One relevant issue is the prevailing interest rate. But another relevant issue is how much money you think people are going to have to spend on rent. If someone tells you real incomes are going to rise faster than you'd previously expected, building the apartment looks better. But then again, if real incomes rise faster than expected you'll also expect interest rates to rise which cuts in the other direction.
So if someone comes along and says "this is a special case—rates are staying ultra-low even if some unexpected good news shows up" that has a big impact on your thinking. And since the very act of building the apartment tends to increase real incomes (gotta hire people) the commitment serves to supercharge the impact of any good news.