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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 Address: Central Bank of the Republic of Turkey Head Office Research and Monetary Policy Department İstiklal Caddesi No: 10 Ulus, 06100 Ankara, Turkey Phone: +90 312 507 54 02 Facsimile: +90 312 507 57 33 The views expressed in this working paper are those of the author(s) and do not necessarily represent the official views of the Central Bank of the Republic of Turkey. The Working Paper Series are externally refereed. The refereeing process is managed by the Research and Monetary Policy Department. 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 Amato, J., and Shin, H., 2003. "Public and Private Information in Monetary Policy Models," BIS Working Paper, 138, Monetary and 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 Central Bank of the Republic of Turkey Recent Working Papers The complete list of Working Paper series can be found at Bank’s website (http://www.tcmb.gov.tr). 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