Download A Literature Overview of the Central Bank’s Knowledge Transparency M. Haluk GÜLER

WORKING PAPER NO: 13/07
A Literature Overview of the Central
Bank’s Knowledge Transparency
February 2013
M. Haluk GÜLER
© Central Bank of the Republic of Turkey 2013
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A Literature Overview of the Central Bank’s Knowledge Transparency
Abstract
Central bank transparency has received great deal of attention in recent years.
However, the theoretical literature has not yet reached a consensus on the effect a
higher degree of transparency has on economic welfare. In this paper, we focus
one aspect of transparency, the transparency of ‘knowledge’ which refers to the
disclosure of central bank forecasts about economic variables. In view of the
ongoing
theoretical
disagreement
concerning
the
economic
effects
of
transparency, this paper provides an overview of the literature by looking first at
the earlier studies built on the time-inconsistency models in the Barro-Gordon
theoretical framework. We then investigate more recent strands of literature,
which rely on the assumption that central banks are credible. Last, we conclude on
the economic reasons for the mixed results of models and briefly mention the
scope for further research.
1
Introduction
The last two decades witnessed a marked tendency toward more
transparent conduct of monetary policy. This intensified focus on
transparency, which can be defined as the elimination of asymmetrical
information between monetary policy makers and other agents in the
economy, is to a large extent the result of a move toward greater central
bank independence and the adoption of explicit inflation targeting in the
early 1990s.
From a political perspective, it is believed that more transparent
behavior of central banks strengthens democratic legitimacy and improves
the accountability of central banks which have become more independent.
Despite the political desirability of transparency, the academic literature has
not yet reached a consensus on the effect a higher degree of transparency
has on economic welfare.
In principle, the provision of better information should reduce
uncertainty, leading to a better inference of shocks and more efficient
pricing and investment decisions -this assumes that markets make efficient
use of the available information- and improve credibility of monetary policy
leading to a more favorable environment for monetary policy and more
stable economic development.
Challengers to this argument on potential benefits have stressed in a
number of theoretical studies that there may be limits and economic costs
to transparency. First, information may carry too much weight in the
public’s decisions and therefore lead to inefficient high volatility in the
aggregate output. Furthermore, given that central banks operate in an
environment where there is considerable uncertainty about how the
economy works, the surprises the future may hold, and how agents’
expectations are formed, the transparency of the central bank’s view of the
economy may need to be revised and this revision may lead to a
deterioration of the central bank’s credibility. In addition, a sudden
deviation in the central bank’s policy that can be observed by the public
may lead to undesirable ex-post-facto changes in the expectations and
consequent behavior of private agents.
The central bank transparency is a multifaceted concept and the great
variety of findings offered in the related literature indicates that desirability
of transparency depends in part on different model specifications1 and the
specific concept. In other words, what aspects of monetary policy are
analyzed is an important determinant of the economic desirability of
transparency. In a recent survey of the literature, Geraats (2002) identifies
1See
Table 1 and Table 2
five aspects of transparency that correspond to different stages in the
policy-making process: political, economic, procedural, policy and
operational. Noting the substitutability between Geraats’s taxonomies of
transparency, Hahn (2002) proposes an alternative subdivision into three
aspects of transparency: goal, knowledge and operational transparency.
These categories respectively refer to openness in policy objectives,
transparency on economic data and model, and openness in decision
making process and policy actions. In fact, there is a rough concordance
between Geraats’s classification of transparency and that of Hahn (2002);
Hahn’s goal transparency corresponds to Geraat’s political transparency, his
notion of knowledge transparency matches with Geraats’s economic and
operational transparency, and Hahn’s transparency with respect to
operations
approximately
corresponds
to
procedural
and
policy
transparency in Geraats’s terminology.
Following Hahn (2002), this paper is focused on the transparency of
knowledge (or the concept of economic transparency according to Geraats
(2002)). As defined by Hahn (2002), the term knowledge transparency2
refers to the disclosure of central bank forecasts about economic variables
2
“Transparency” and “Knowledge transparency” will be used interchangeably throughout
this paper.
such as inflation, the real economic data, and the economic model used
inside the central bank to forecast inflation. In view of the ongoing
theoretical disagreement concerning the economic effects of transparency,
this paper seeks (i) to provide an overview of the relevant literature and (ii)
to analyze the economic reasons for differences in the conclusions of
selected studies with respect to the desirability of knowledge transparency.
The evolution of the knowledge transparency literature will be discussed
by looking
first at the earlier studies built on the time-inconsistency models in the
Barro-Gordon theoretical framework that discuss the credibility problem of
the central bank. We will then consider more recent strands of literature on
the economic desirability of transparency, which rely on the assumption that
central banks are credible and their preferences are on average known by
the public.
Theoretical Insights
Before discussing these two groups of literature, we will examine some
of the focal arguments in both frameworks. Following Kydland and Prescott
(1977) and later Barro and Gordon (1983), much of the earlier work on
knowledge transparency assumed that the central bank prefers an economic
output level higher than the potential output, since imperfections in the
economy reduce the potential output below the socially optimal level. In
this framework, the assumed timing of events implies that the central bank
is in some way able to respond flexibly to disturbances in the economy since
the public is unable to change its economic actions in the short term. Hence,
the central bank will have a strong incentive to pursue a discretionary policy
that is more expansionary than firms or people expect and to boost
economic output over the short run by raising inflation above expected
inflation. As an interpretation of the time-inconsistency problem, this
attempt will only result in an ‘inflation bias’ since the economic agents with
rational expectations will consider the central bank’s commitment to low
inflation as weak and will incorporate a higher inflation rate than it would be
under a credible regime. The central bank’s preference results in an
inefficient equilibrium due to the undesired outcome of excess inflation.
Thus, the bank faces a trade-off between the reputation (credibility)
problem due to an inflation surprise and loosing flexibility to stabilize the
shocks. The main objective of the earlier literature within the Barro-Gordon
framework was to analyze whether greater knowledge transparency helps
to reduce the inflation bias and the time inconsistency problem, and
whether it improves the central bank’s credibility in conducting monetary
policy.
The Barro-Gordon argument of this earlier literature has been
challenged in numerous studies. In analyzing the economic effects of
knowledge transparency, these more recent studies adopt the contrary
assumption that the central bank prefers to keep output close to the
potential level and to control inflation.3 In this modern framework, the
central bank no longer faces a credibility problem due to time-inconsistency.
One of the main arguments behind this shift in understanding asserts that
the output in a state of equilibrium equals the natural level, but inflation is
above the optimal level. Therefore, central banks would eventually
appreciate that they cannot consistently boost economic output above its
potential this would be inflationary and they would give up behaving in a
discretionary fashion (see McCallum (1997) for further discussion). Also,
most central banks are now believed to be well-established and credible.
Based on institutional evidence, it is suggested that today’s central banks
in fact target the expected natural output level (see Blinder 1998).
Moreover, the new theoretical research strands addressed different
issues, specifically imperfect common knowledge. Since the ‘forecasting the
forecasts of other problem’ caused by differential information is solved,
following Woodford (2001), several papers analyzed the effects of
3Such
as Cukierman 2001, Jensen 2002, Gersbach 2003, Walsh 2007.
transparency using the models based on heterogeneous information rather
than assuming homogeneously informed agents. Under imperfect common
knowledge and heterogeneous information, economic agents have different
information sets with regard to economic disturbances. This leads to
higherorder uncertainty where the agents are also uncertain about the
‘others’ expectations of others’ expectations’. Such a mechanism causes
delays and rigidities in strategic decisions; thus, a transitory shock turns out
to have highly persistent effects on the economy (Woodford 2001). Since
transparency homogenizes the information sets of agents and facilitates
coordination in agents’ strategic decision, it has important effects on
economic welfare. However, the work of Morris and Shin (2002) and several
other papers pointed out that transparency is actually a double-edged
sword if there are strategic complementarities and heterogeneous
knowledge among agents. Besides facilitating coordination, public
information may result in greater overreaction to information in the sense
that private agents assign too much weight to public information and can be
distracted from its real value. Thus, the cost of transparency may outweigh
the benefits, especially when the public information is noisy and may
become detrimental to welfare.
This paper is structured as follows. In Section 2, we provide an
overview of the early models built on the Barro-Gordon framework. In
Section 3, we discuss the policy models in more recent framework that
considers well-established and credible central banks. We conclude on the
findings of the theoretical literature and discuss the scope for further
research in Section 4.
2
Selected Studies within the Barro-Gordon Framework
The theoretical framework initially developed by Barro and Gordon
(1983) forms the basis for most of the earlier work on the economic effects
of central bank transparency. Barro and Gordon (1983) proposed that, in
order to eliminate the inflation bias and the time inconsistency problem as
well as to improve credibility, the central bank should abandon discretionary
policies and commit to a rule. However, when asymmetric information
about economic disturbances exists, reducing the inflation bias through
implementing Barro and Gordon’s initial proposal of pre-commitment would
not be sufficient.
The work of Canzoneri (1985) was the first one modifying the BarroGordon framework to allow for asymmetric information in monetary policy
games. He analyzed the credibility of the central bank and suggested that
the central bank has private information about the forecast of money
demand disturbances. In the case when the central bank discloses its
forecast about the demand shock, since the private sector cannot verify
whether the central bank’s claim is true, the inflation bias caused by time
inconsistency gets more difficult to eliminate. Unlike Barro and Gordon’s
(1983) conclusion, Canzoneri (1985) suggested that in order to reduce the
inflation bias, the central bank should commit to flexible targeting rules
rather than simple rules. Flexible targeting rules would include some
latitude for discretion and the central bank would be able to respond to its
private information. Thus, his analysis could be interpreted in a way that
with a flexible targeting rule, the central bank would choose to be fully
transparent and this leads to an efficient Nash equilibrium which is optimal
for the central bank and the society.
The early literature generally studied knowledge transparency when
there is ambiguity over the central bank’s goal. In the same fashion,
Cukierman and Meltzer (1986) analyzed the case where there is asymmetric
information about both the central bank’s preference parameter for
stimulating output that follows an AR(1) process and the monetary control
errors. In other words, they examined the setting where there is
simultaneous ambiguity both in goals and in monetary control error. The
public cannot distinguish between the control error and the persistent shifts
in the setting of policy instruments. While the central bank cannot
consistently surprise the public in the Barro-Gordon model, Cukierman and
Meltzer (1986) suggested that control errors in the policy instrument make
it easier for the central bank to use inflation surprises, since control errors
mask the true intention of the central bank. The public cannot directly
monitor the preference parameter, but it can draw inferences from past
money supply growth. In Cukierman and Meltzer’s analysis, greater
transparency, which implies less ambiguous control procedures, helps the
public to better forecast future money growth rate and to expect higher
inflation based on the central bank’s deviations. Thus, transparency may
raise the cost of using inflation surprises while it helps sustain the
commitment to low inflation rate. However, if the central bank has relatively
unstable objectives, transparency would not be an optimal solution. The
central bank with unstable objectives would have an incentive to
deliberately choose a higher control error in order to mask its intention and
may choose to be less transparent, which in turn makes it less credible.
Faust and Svensson (2001) extended the Cukierman and Meltzer
(1986) model in two ways: First, they changed the economic welfare
function from linear to quadratic in both output and inflation by including
the variance of employment rather than the absolute value of
employment. Since the variance of employment affects welfare
negatively, a quadratic welfare function results in lower economic gains
from temporary rise in employment.4 Thus, in Faust and Svensson (2001),
minimizing the variability of employment becomes an important issue in
the quadratic welfare function. Second, control errors are assumed to be
partially observable by the public. A drawback in Cukierman and
Meltzer’s (1986) work is that transparency was not distinguished from
monetary
control
error.
Faust
and
Svensson
(2001)
explicitly
distinguished monetary control errors from transparency. In this model,
transparency referred to the extent to which information on control
errors is released to public. For a given level of monetary control error,
knowledge transparency leads to stronger responding to inflation in the
public’s expectations. As a result of the two changes in Faust and
Svensson’s model, inflation surprises would result in higher realized
inflation and higher reputation cost than the case discussed by
Cukierman and Meltzer’s (1986) model. As a result, in this setting, Faust
and Svensson (2001) found that the central bank with unobservable
output targets would tend not to use inflation surprises to avoid
increased reputation cost. This would result in lower output variability
4See
Walsh (2003), pp. 366
and lower average inflation; thus, contrary to Cukierman and Meltzer
(1986), transparency is found to be generally welfare improving.
Barro and Gordon (1983) proposed that, in order to eliminate the
inflation bias and the time inconsistency problem as well as to improve
credibility, the central bank should abandon discretionary policies and
commit to a rule. However, when the central bank’s preferences are
stochastic and ambiguous, reducing the inflation bias through precommitment as suggested by Barro and Gordon (1983) would be insufficient
even when there is no time-inconsistency problem. Building on the
assumption of asymmetric information in the central bank’s goal, which was
first introduced by Cukierman and Meltzer (1986), Geraats (2001b)
employed a time-consistent twoperiod model where the private sector is
able to respond to both the central bank’s action and its announcement,
contrary to the assumed timing of events in BarroGordon (1983). Geraats
(2001b) used the Barro-Gordon type of welfare function, which is linear in
output and performs in a setting where there are demand and supply shocks
in the economy that are observed by the central bank, but cannot be known
by the public. It was shown that under this setting, although there is no time
inconsistency, asymmetry in information about the shocks as well as the
central bank’s goal (inflation target) still creates inflation bias. The reason is
that the public can only observe the interest rate. Although the variations in
the interest rate provide a signal about the central bank’s intentions, they
also reflect the economic disturbances. According to this model, with
greater knowledge transparency, which means that the central bank
discloses its private information on the size of shocks, the central bank’s
inflation target become more visible; thus, the public’s expectations become
more responsive to the central bank’s inflation target and the cost of
inflation surprises increases. As a result, similar to Faust and Svensson
(2001), knowledge transparency reduces the inflationary bias like an implicit
commitment and increases the central bank’s credibility. Hence, Geraats
(2001b) found that knowledge transparency plays a key role in eliminating
the inflation bias.
One might wonder whether the conclusions on the economic effects
of knowledge transparency in the Barro-Gordon framework would change
under different model specifications. Both Faust and Svensson (2001) and
Geraats (2001b) used the Lucas island type of model where the prices can
be adjusted every period and expectations about future economic
conditions do not need to affect the prices today. As discussed above, Faust
and Svensson (2001) and Geraats (2001b) both concluded that transparency
increases the cost of using inflation surprises for the central bank that cares
about its reputation; thus knowledge transparency under unobservable
goals of the central bank improves the welfare by reducing the inflation
bias. However, in a New-Keynesian model, since the prices do not adjust
every period, expectations about the future values of relevant economic
variables play an important role for the current realizations of price and
output. In such a forward-looking model, transparency affects the current
realizations of the variables much more strongly. This causes relevant
variables to be more volatile in the current period.
Drawing on a number of aspects of Faust and Svensson (2001), but
leaving out the Lucas supply curve, Jensen (2002) applied the New
Keynesian specification of the Phillips curve for two periods in his model and
studied the economic desirability of transparency with regard to the central
bank’s control error. Employing a forward-looking model, he found that with
more transparency, the public draws better inferences about the changes in
the central bank’s objectives and the public’s expectations become much
more responsive which leads actual inflation to become more variable. In
this case, the central bank focuses relatively more on stabilizing inflation.
Such a focus requires flexibility to use discretionary policies. Although
transparency increases the marginal cost of inflation due to increased
variability, it benefits the central bank with poor inflation credibility as the
central bank would pursue more disciplined policy to achieve higher
credibility. On the other hand, for an already credible central bank, flexibility
to stabilize inflation would be more important to have. Therefore, unlike
Geraats (2001b) and Faust and Svensson (2001) who concluded that
transparency would always be optimal, Jensen (2002) found that the
economic benefits of transparency, which enhance the central bank’s
credibility, would not always outweigh the cost of losing the flexibility to
stabilize the shocks. According to him, the central bank’s initial credibility
determines the optimal transparency level due to the flexibility-credibility
trade off.
Employing a perspective different from the papers discussed above,
Hellwig (2002) analyzed the welfare effects of knowledge transparency
within the same BarroGordon framework, but in a model of monopolistic
competition among heterogeneously informed agents. He assumed that the
central bank controls the growth rate of nominal GDP with some error
(monetary policy shock) and defined transparency as the information
disclosures about the monetary shock. Thus, the public can observe the
growth of nominal GDP from both the central bank’s discretionary monetary
expansion and the monetary shock. Based on the arguments of Morris and
Shin (2002), he suggested that knowledge transparency has two conflicting
effects under information heterogeneity; on the one hand, by reducing
higher-order uncertainty, it leads prices to adjust faster and monetary
shocks on output to be smaller and less persistent. In this case, the central
bank would be less likely to engage in inflation surprises as they would be
more costly; therefore, with transparency, the inflationary bias would be
eliminated as if the central bank had an implicit commitment. On the other
hand, given the strategic complementarities and heterogeneous knowledge,
transparency may result in greater overreaction to information in the sense
that private agents assign too much weight to public information and can be
distracted from its face value. The cost of transparency may outweigh the
benefits, especially when the public information is noisy. As a result, he
showed that transparency about the monetary shock does not always
improve welfare and may become detrimental depending on the noise of
public information. On the other hand, if Hellwig’s (2002) model is examined
for a setting with homogeneously informed agents and the information
asymmetry is removed across private agents, transparency could reduce the
inflationary bias and improve welfare, which supports the findings of Faust
and Svensson (2001) and Geraats (2001b).
Following Cukierman and Meltzer (1986), most theoretical studies
in this literature generally looked at the economic effects of information
disclosures about economic shocks when the central bank’s goal is not
perfectly observable. These papers generally assumed that there is
ambiguity in both the central bank’s goal (e.g.inflation target) and the shock.
However, as an exception to this fashion other than the work of Canzoneri
(1985), Gersbach (2003) analyzed the effects of transparency under the
Barro-Gordon framework assuming that the public can perfectly observe
preferences of the central bank, but cannot observe the real shock. The
central bank may or may not be informed about the real shock. In this
model, the central bank completely controls inflation through money
supply. Under opaqueness, the public tries to draw inferences about the
supply shock by looking at the central bank’s inflation target (or money
supply). Transparency in this model is the information disclosure on the
central bank’s observation of the supply shock. The information disclosures
by the central bank always can be verified by the public, which is in contrast
to the assumption of Canzoneri (1985). It is concluded in the model that
transparency of the central bank’s economic assessment about the supply
shock leads the public to anticipate the central bank’s inflation response and
thus makes the stabilization infeasible. As a result, transparency would
always be detrimental to welfare.
Overall, inspired by the influential work of Cukierman and Meltzer
(1986), the early theoretical papers within the Barro-Gordon framework
generally analyzed knowledge transparency in the case when the central
bank’s goal is unobservable and there is asymmetrical information about
economic disturbances. A prevalent conclusion is that transparency plays a
key role in reducing the inflation bias while it would result in less flexibility
to stabilize economic shocks. The economic desirability of transparency
depends on the credibility-flexibility trade off and it is highly sensitive to
model specifications and the setting.
For instance, although Cukierman and Meltzer (1986) concluded that
transparency would not be an optimal policy for a central bank with
unstable objectives, the more convincing specification introduced by Faust
and Svensson (2001) suggests that transparency is desirable due to the use
of a quadratic welfare function rather a linear one and the explicit
distinction between control error and transparency.
Another reason for differences in conclusions about the desirability of
transparency is the type of economic models. When a New-Keynesian
model is introduced rather than the commonly-employed Lucas island type,
as shown in the work of Jensen (2001), inflation expectations play a key role
in determining the desirability of transparency.
Last but not least, introducing information heterogeneity into the Barro-
Gordon framework would lead the private sector to overreact to public
information and this would outweigh the benefits of transparency in
reducing the inflation bias.
3
Selected Studies within Modern Framework
In contrast to the earlier models of the Barro-Gordon type, more recent
studies in the modern framework imply that the central bank never wants
unemployment to differ from its natural level and no longer faces a
credibility problem which is linked to unpredictable policies and money
supply control.
Tarkka and Mayes (1999) applied a Lucas supply curve and assumed that
the central bank has only one objective, which is stabilizing the rate of
inflation around a stochastically changing target that cannot be observed by
the public. In this model, the central bank sets the money supply in
response to the velocity shock and inflation expectations of the public,
which is not perfectly observable by the bank. Transparency implies
disclosure of the central bank’s assessment of the public’s inflation
expectations. Under the transparent case, the private sector is less likely to
make miscalculations based on their perceptions of how the central bank
observes the public’s inflation expectations; thus, the private sector’s ability
to forecast the inflation target is improved. This helps the central bank
achieve its inflation target and conduct monetary policy more effectively.
Unlike Tarkka and Mayes (1999), Geraats (2001a) assumed that the
central bank has two goals: stabilizing both economic output around its
natural level and the inflation around its target rate, which is stochastically
changing around its expected value and cannot be observed by the public. In
this analysis, a two-period model is employed that assumes there are
demand and supply shocks in the economy: Transparency is defined as
releasing information about these shocks. Under a policy of opacity, when
the central bank changes the interest rate to stabilize the shocks, and in this
way it does signal both its inflation target and the shock. However, this
results in undesirable changes in the public’s inflation expectations. Thus,
the central bank would attempt to smooth the interest rate in order to ease
these undesirable shifts and would be unable to offset the shocks. In such a
case, the increase in transparency is desirable since the private sector can
more accurately forecast the central bank’s inflation target by looking at its
actions. This provides central bank with greater flexibility to stabilize the
shocks.
Cukierman (2001) analyzed the effects of transparency using two
different models; the Lucas island model and the backward-looking
Keynesian model. In the first model, he analyzed a setting where the central
bank pursues flexible inflation targeting and both inflation and output goals
are fully observable by the public whereas there is asymmetric information
about the supply shock. Since neither inflation bias nor the timeinconsistency problem arises in this setting, there is no trade-off between
the credibility and flexibility of the central bank. Instead, since the central
bank has two goals, it faces a trade-off between inflation and output gap
stabilization. In this model, the supply shock occurs before the inflation
expectation of the private sector is set. If central bank discloses information
about the supply shock, private agents adjust their expectations according
to this information; as a result, the central bank would not be able to
stabilize the output by using the inflation surprises implied in the Lucas
setting. Because of the trade-off between inflation and output stabilization,
the central bank might better maintain its information advantage and be
opaque about its forecasts. This would enable the central bank to be flexible
to optimize the effects of supply shocks. In the second model, which is the
backward-looking Keynesian type, reducing the interest rate volatility is
included into the central bank’s objective function along with reducing
inflation and output volatility. Inflation is determined by lagged output and
demand shock, and the output depends on the expected real interest rate
and the supply shock. In this mechanism, a change in the nominal interest
rate affects inflation with a lag of one period; thus, it will not lead to a
change in expected real interest rate. Thus, transparency would not affect
output and inflation variability, but it will result in higher volatility of interest
rates, which is undesirable by the central bank.
It might be interesting to test the conclusions of Cukierman (2001) which
were based on the backward-looking Keynesian model in a forward-looking
type. In fact, as discussed in the previous section, Jensen (2002) examined
the effects of knowledge transparency by applying the forward looking
Keynesian model.5 Jensen (2002) falls with in Barro-Gordon framework, he
also analyzed the case where the central bank pursues a flexible inflation
targeting policy, which implies that the central bank is credible. In this
model, with more transparency, the public draws better inferences about
the changes in the central bank’s objectives and the public’s expectations
become much more responsive. This leads to increased variability in actual
inflation. In this case, the central bank focuses relatively more on stabilizing
inflation, a task which requires flexibility. Thus, transparency is detrimental
to economic welfare when the central bank adopts flexible inflation
5Also
Gersbach (2003) verifies the results presented by Cukierman (2001) by taking the
bias in his welfare function zero.
targeting.
Information is essential for transmission mechanisms. The task of
addressing the effects of knowledge transparency under imperfect common
knowledge has recently received a great deal of attention. As is known, in
homogeneous information settings, economic agents try to guess only the
uncertain economic fundamentals whereas in heterogeneous information
settings, agents also try to forecast the other agent’s forecast about the
economic fundamentals. The differential information in the latter setting
causes delays and rigidities in strategic decisions; thus, a transitory shock
turns out to have highly persistent effects on the economy (Woodford
2001). Since transparency homogenizes the information sets of agents and
facilitates coordination in the agents’ strategic decision, it has important
effects on economic welfare. However, the work of Morris and Shin (2002)
pointed out that transparency is actually a double-edged sword if there are
strategic complementarities and heterogeneous knowledge among agents.
Besides facilitating coordination, public information may result in greater
overreaction to unsettling information if private agents assign too much
weight to the public information and excess focus on the information
released by the central bank can distract private sector agents from other
crucial information.
Drawing on a number of aspects of Morris and Shin’s conceptual
framework, Amato and Shin (2003) analyzed knowledge transparency under
monopolistic competition among heterogeneously informed agents. In this
model, it is assumed that the central bank employs price level targeting
where private agents have imperfect and heteregeneous information about
the natural rate of interest, which is stochastically changing. Due to
information heterogeneity, private agents are also uncertain about the
information sets of other private agents. Therefore, they try to secondguess the pricing decisions of these competitors. Strategic complementaries
amplify this activity of private agents. In such a case, greater transparency
would cause firms to overreact to public information and react less to their
own information. As a result, it may lead to increased volatility of output
and inflation and indeed be detrimental to economic welfare.
The way the central bank’s objective function is structured may play an
important role in determining the economic welfare effects of public
information disclosures. Indeed, in heterogeneously informed agent models,
micro-founded welfare functions that are derived directly from the model
may have critical differences when compared to the standard quadratic
welfare functions. In micro-founded welfare functions, in addition to output
and price level variance, relative price dispersion across firms is included.
Greater transparency increases the volatility of the price level while it
reduces the relative price dispersion among firms. Therefore, the net
welfare effect would depend on relative changes in these two variables.
Hellwig (2005) interpreted this in a heterogeneously informed agent setting
and suggested that standard quadratic objective functions undervalue the
gains from transparency. In his model, he analyzed the effects of
transparency using a monopolistic competition model with heterogeneously
informed agents and assumed that the central bank’s objective function is
micro-founded rather than standard quadratic. Also, in this model, money
supply follows a random walk process and monetary policy is implemented
through public announcements. Heterogeneous information delays price
adjustments and causes the real effects of shocks to be larger. Under this
setting, he found that knowledge transparency about monetary shocks
always increases welfare. The reason is that public disclosures always
reduce relative price dispersion across firms and reduce adjustment delays
caused by higher-order uncertainty. Transparency does, however, incur
higher volatility costs, which are due to increased information noise.
Indeed,
implementation
of
monetary
policy
through
public
announcements may be a naive assumption. Taking a more realistic case,
Lorenzoni (2009) assumed that monetary policy follows an optimal policy
rule (backward looking interest rate rule) rather than a stochastic one. He
showed that public information disclosure about productivity shocks always
improves economic welfare since this information enables relative prices to
be set parallel to the productivity differentials. This gain always
compensates for any losses that arise from aggregate output volatility.
The previously mentioned papers only considered the Lucas island type
models except for the work of Cukierman (2001), which employed a
backward looking Keynesian model. Walsh (2007) analyzed the case in a
New-Keynesian model with heterogeneous information. In this setting, the
central bank employs a standard quadratic objective function and
implements a flexible inflation targeting regime. Interestingly, he showed
that increasing the degree of transparency turns out to be optimal only
when the central bank is better at forecasting supply shocks. Reducing the
degree of knowledge transparency is optimal when the central bank is
better at forecasting demand shocks. What drives this result is that under
transparency, the central bank achieves greater flexibility in responding to
anticipated supply shocks while it can no longer completely offset
anticipated demand shocks without causing undesirable changes in the
public’s inflations expectations.
In another study, Walsh (2008) incorporated a new Keynesian model
with monopolistic competition and heterogeneous information. The main
difference from his earlier study is that he used a micro-founded objective
function which incorporates relative price dispersion into the model. The
central bank and firms are assumed to have noisy information about the
shocks. He considers two policy regimes; a fully opaque regime and a fully
transparent regime. The central bank is assumed to operate in a
discretionary manner in setting its policy instrument while it commits to
either a transparent or opaque regime. Consistent with the work of Hellwig
(2005), he found that more precise public information always lowers relative
price dispersion across firms and improves economic welfare.
An overall conclusion is that in the modern framework, when there is no
timeinconsistency problem, the economic desirability of transparency is
determined not by the earlier trade off between the central bank’s
credibility and flexibility to stabilize economic disturbances, but by the trade
off between inflation and the output gap. The results of models are highly
sensitive to three factors: (i) model specification, as whether the central
bank’s inflation target is explicit or implicit, (ii) information setting, as
whether it is homogeneous or heterogeneous, and (iii) type of the welfare
function.
First, when the central bank’s inflation target is implicit, as in the work of
Tarkka and Mayes (1999) and Geraats (2001a), under knowledge
transparency, the public’s ability to infer the central bank’s target will be
improved leading to a more effective conduct of monetary policy. However,
when there is an explicit inflation target, as in the case discussed by
Cukierman (2001) and Jensen (2002), under transparency about the supply
shock, the public will adjust their expectations according to this information;
thereby, the central bank would not be able to stabilize the output by using
inflation surprises; this would lead to reduced economic welfare.
Second, the economic outcomes of transparency are more interesting in
the heterogeneous information setting where information plays an
important role in transmission mechanisms and in the inflation-output gap
trade off. Once information heterogeneity is introduced into the models,
higher-order expectations as well as the noise of information play a role in
shaping the way transparency affects inflation. In the heterogeneous
information setting, conclusions on transparency are generally conditional
on the noise of public information.
Another reason for the variety of findings among models in the
heterogeneous information setting is the type of welfare function. Amato
and Shin (2003) and Walsh (2007) suggested that transparency would not
always be optimal when they used a standard quadratic function which
undervalues the gain from public disclosures. However, when using more
convincing models with micro-founded functions, which incorporate relative
price dispersion across firms, Hellwig (2005), Walsh (2008), and Lorenzoni
(2009) concluded that transparency is always welfare-improving.
4
Conclusion
The principle finding of the early literature that analyzed knowledge
transparency within the Barro-Gordon framework is that the key benefit of
transparency is increased credibility whereas the loss of flexibility is the key
drawback. With greater transparency, the public can observe the monetary
policy better which helps the central bank commit to low inflation reducing
the inflation bias. However, greater transparency can also limit the central
bank’s latitude in effectively responding to economic shocks, which may
result in an unstable economy. Thus, greater transparency would be
advisable for central banks if they have a bad reputation and care more
about enhancing credibility rather than the ability to use discretionary
policy. While the prevalent result favoring knowledge transparency is quite
robust across the earlier studies discussed, there are cases where model
specifications lead to a conclusion that transparency would not be optimal
(e.g. New-Keynesian model in Jensen (2002)).
In contrast to the earlier models in the Barro-Gordon framework, more
recent strands of theoretical literature strongly suggest that the central
bank prefers to keep output close to the potential level and that its goal is to
control inflation. In this modern framework, the central bank no longer
faces a credibility problem linked to the time-inconsistency problem.
Indeed, model specifications incorporated in this modern framework such
as information heterogeneity and micro-founded welfare functions lead to
different conclusions across the studies that are discussed. For instance,
models with heterogeneous information setting suggest that transparency is
generally conditional on the noise of public information. Within the
heterogeneous information context, however, models that use the microfounded welfare function, which is more sophisticated due to the inclusion
of relative price dispersion across firms, conclude that transparency is
always the optimal regime for the central bank.
This review did not seek to identify one ‘best’ model for estimating the
economic effects of transparency. In fact, no model is inherently superior to
the other. Given the mixed results of the selected studies, perhaps the most
important lesson from our comparison across models is that both groups of
literature have not reached a consensus and their findings are highly modelspecific.
It is also worthwhile to mention that there are scopes for future
research about transparency that have not received much attention yet:
today central banks mostly use the nominal interest rate as their monetary
policy instrument, following the so-called Taylor rules which are intended to
reduce the volatility of inflation and/or output. “Taylor rules” has mainly
been modeled under the assumption of perfect labor and credit markets.
However, labor and credit markets are far from perfect. When market
production is subject to frictions in labor market and financial sector and
problems in these sectors magnify the real sector volatility, then a policy
aimed at minimizing the welfare costs of economic fluctuations will need to
expand the list of its objectives beyond the minimization of inflation and
output gap. In the aftermath of the recent financial crisis, much debate has
been focused on this issue and on the CB goals to preserve financial
stability. In addition to that, nonlinearities in relationships during the crisis
and non-crisis periods have emerged as a key issue in understanding the
differences between how CB transparency policy and its economic effects
change in both good and bad financial times. Thus, further work is required
to explore these issues.
References
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Economics Department, BIS.
Barro, R.J., and Gordon, D.B., 1983. "A Positive Theory of
Monetary Policy in a Natural Rate Model," Journal of Political
Economy, 91(1), 589-610.
Blinder, A. S., 1998. "Central Banking in Theory and Practice,"
Cambridge, MA:MIT Press.
Canzoneri, M. B., 1985. "Monetary Policy Games and The Role of
Private Information," American Economic Review, 75(5), 1056-70.
Cukierman, A., and Meltzer, A., 1986. "A Theory of Ambiguity,
Credibility and Inflation under Discretion and Asymmetric
Information," Econometrica, 54, 1099-128.
Cukierman A., 2001. "Accountability, Credibility, Transparency
and Stabilization Policy in Eurosytem," The Impact of EMU on
Europe and Developing Countries, pp. 40-75.
Faust, J., and Svensson, L.E.O., 2001. "Transparency and
Credibility:
Monetary
Policy
with
Unobservable
Goals,"
International Economic Review, 42, 369-97.
Geraats, P. M., 2001a. "Precommitment, Transparency and
Monetary
Policy,"
Deutsche
Bundesbank
Research
Centre
Discussion Paper Series, 12.
Geraats, P. M., 2001b. "Why Adopt Transparency? The Publication
of Central Bank Forecasts," ECB Working Paper, 41.
Geraats, P. M., 2002. "Central Bank Transparency," Economic
Journal, 112, 532-565.
Gersbach, H., 2003. "On the Negative Socil Value of Central Banks’
Knowledge Transparency," Economics of Governance, 4(2), 91-102.
Hahn’ V., 2002. "Transparency in Monetary Policy : A Survey," IFO
Studien Zeitschrift fur Emprische Wirtschaftforschung, 48(3), 42955.
Hellwig, C., 2002. "Public Announcements Delays and the
Business Cycle," Bagwell, K., Staiger, R., 1999. " unpublished
manuscript, UCLA.
Hellwig, C., 2005. "Heterogeneous Information and the Benefits of
Transparency," unpublished manuscript, UCLA.
Jensen, H., 2002. "Optimal Degree of Transparency in Monetary
Policymaking," Scandinavian Journal of Economics, 104(3) 399422.
Kydland, F.E., and Prrescott, E. C, 1977. "Rules Rather than
Discretion: The Inconsistency of Optimal Plans," Journal of
Political Economy, 85(3), 473-91.
Lorenzoni, G., 2009. "Optimal Monetary Policy with Uncertain
Fundamentals and Dispersed Information," Review of Economic
Studies, 77(1), 305-338.
McCallum, B. T., 1997. Crucial Issues Concerning Central Bank
Independence," Journal of Monetary Economics, 39, 99-112.
Morris, S., and Shin, H. S., 2002. "Social Value of Public
Information," American Economic Review, 92(5), 1521-1354.
Tarkka, J. and Mayes, D., 1999. "The Value of Publishing
Official Central Ban Forecasts," Bank of Finland Discussion
Paper, 22.
Walsh, C.E., 2007. "Optimal Economic Transparency,"
International Journal of Central Banking, 3(1), 5-36.
Walsh, C.E., 2008. "Announcements and The Role Policy
Guidence," FED of St. Louis Review, 90(4), 421-42.
Woodford, M., 2001. "Imperfect Common Knowledge and the
Effects of Monetary Policy," NBER Working Paper, 8673.
No
Yes
Observed CB goals
3
Homogeneous
Linear
Lucas
1
3
Homogeneous
Standard
Quadratic
Lucas
Agents set prices
CB sets its instrument
Agents Information Set
Loss Function
Model
1
2
Shock and its
announcement occurs
2
Yes
Not
Necessarily
Yes
Transparency improves welfare
* Numbers represent the ordering of the events.
Lucas
Standard
Quadratic
Homogeneous
3
1
2
No
Faust and
Svensson
(2001)
Cukierman and
Meltzer
(1986)
Squence of Events *
Canzoneri
(1985)
Lucas
Linear
Homogeneous
2
3
1
No
Yes
Geraats
(2001)
New-Keynesian
Standard
Quadratic
Homogeneous
3
1
2
No
Not
Necessarily
Jensen
(2002)
Standard
Quadratic
Lucas
Lucas
(Monopolistically
Competitive
Firms)
Homogeneous
3
2
1
Yes
No
Gersbach
(2003)
Standard
Quadratic
Heterogeneous
3
2
1
No
Not
Necessarily
Hellwig
(2002)
Table 1: Comparision of the Selected Papers in the Barro-
Gordan Framework
2
3
Agents set
prices
CB sets its
instrument
2
3
1
3
2
1
Yes
No
Cukierman
(2001)
Standard
Quadratic
Lucas
Standard
Quadratic
Lucas
Loss Function
* Numbers represent the ordering of the events.
Model
Standard
Quadratic
Homogeneous
3
1
2
Yes
No
Jensen
(2002)
Lucas/Backwar
d looking
Keynesian
New-Keynesian
Standard
Quadratic
Agents Information Set Homogeneous Homogeneous Homogeneous
1
No
No
Observed CB goals
Shock and its
announcement
occurs
Yes
Geraats
(2000)
Yes
S q u en ce o f E ven ts *
Transparency improves
welfare
Tarkka and
Mayes
(1999)
Lucas
Standard
Quadratic
Homogeneous
3
2
1
Yes
No
Gersbach
(2003)
Micro-Founded
Heterogeneous
2
3
1
Standard
Quadratic
Heterogeneous
2
3
1
No
Not
Necessarily
Walsh
(2007)
Lucas
Lucas
(Monopolistically (Monopolistically
Competitive
Competitive
Firms)
Firms)
New-Keynesian
Standard
Quadratic
Heterogeneous
2
3
1
No
Yes
Not
Necessarily
No
Hellwig
(2005)
Amato and
Shin
(2003)
Micro-Founded
Heterogeneous
1
3
2
No
Yes
Lorenzoni
(2009)
Lucas
(Monopolistically
Competitive
New-Keynesian
Firms)
Micro-Founded
Heterogeneous
2
3
1
No
Yes
Walsh
(2008)
Table 2: Comparision of the Selected Papers in the Modern
Framework
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