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Listening without understanding: Central Bank transparency, financial markets and the crowding out of private information

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Author Info

  • C.J.M. Kool
  • S. Rosenkranz
  • M. Middeldorp

Abstract

The trend of monetary policy transparency has recently extended itself to the practice of providing guidance on the likely direction of policy rates. There is a risk that communicating the central bank’s own outlook for interest rates actually undermines the financial markets’ ability to predict monetary policy. This paper analyzes this risk using the Diamond (1985) model of a financial market, which includes both costly private information acquisition and a costless public signal. We demonstrate that a sufficiently precise signal from the central bank can result in a deterioration of the financial market’s ability to predict monetary policy through the crowding out of private information acquisition. Central banks could alleviate this risk with a policy of limiting the guidance offered to the financial market in order to leave sufficient scope for private information acquisition.

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Bibliographic Info

Paper provided by Utrecht School of Economics in its series Working Papers with number 07-19.

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Length: 29 pages
Date of creation: 2007
Date of revision:
Handle: RePEc:use:tkiwps:0719

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Keywords: Interest Rates; Monetary Policy; Information and Financial Market Efficiency; Communication; Transparency; Information Acquisition;

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References

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  1. David Cobham, 2003. "Why does the Monetary Policy Committee smooth interest rates?," Oxford Economic Papers, Oxford University Press, vol. 55(3), pages 467-493, July.
  2. Marvin Goodfriend, 1985. "Monetary mystique : secrecy and central banking," Working Paper 85-07, Federal Reserve Bank of Richmond.
  3. Guido Tabellini, 1986. "Secrecy of Monetary Policy and the Variability of Interest Rates," UCLA Economics Working Papers 426, UCLA Department of Economics.
  4. David H. Romer & Christina D. Romer, 2000. "Federal Reserve Information and the Behavior of Interest Rates," American Economic Review, American Economic Association, vol. 90(3), pages 429-457, June.
  5. Maria Demertzis & Andrew Hughes Hallett, 2004. "Central bank transparency in theory and practice," Money Macro and Finance (MMF) Research Group Conference 2003 23, Money Macro and Finance Research Group.
  6. Wolfers, Justin & Zitzewitz, Eric, 2006. "Prediction Markets in Theory and Practice," CEPR Discussion Papers 5578, C.E.P.R. Discussion Papers.
  7. Diamond, Douglas W. & Verrecchia, Robert E., 1981. "Information aggregation in a noisy rational expectations economy," Journal of Financial Economics, Elsevier, vol. 9(3), pages 221-235, September.
  8. Stephen Morris & Hyun Song Shin, 2002. "Social Value of Public Information," American Economic Review, American Economic Association, vol. 92(5), pages 1521-1534, December.
  9. Lars O. Svensson & Robert J. Tetlow, 2005. "Optimal Policy Projections," NBER Working Papers 11392, National Bureau of Economic Research, Inc.
  10. Michael Woodford, 2005. "Central-bank communication and policy effectiveness," Discussion Papers 0506-07, Columbia University, Department of Economics.
  11. Verrecchia, Robert E., 2001. "Essays on disclosure," Journal of Accounting and Economics, Elsevier, vol. 32(1-3), pages 97-180, December.
  12. Athanasios Orphanides & John C. Williams, 2005. "Inflation scares and forecast-based monetary policy," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(2), pages 498-527, April.
  13. Geraats, P.M., 2004. "Transparency and Reputation: The Publication of Central Bank Forecasts," Cambridge Working Papers in Economics 0473, Faculty of Economics, University of Cambridge.
  14. Eijffinger, Sylvester C W & Hoeberichts, Marco & Schaling, Eric, 2000. "A Theory of Central Bank Accountability," CEPR Discussion Papers 2354, C.E.P.R. Discussion Papers.
  15. Diamond, Douglas W, 1985. " Optimal Release of Information by Firms," Journal of Finance, American Finance Association, vol. 40(4), pages 1071-94, September.
  16. Eric T. Swanson, 2004. "Federal Reserve transparency and financial market forecasts of short-term interest rates," Finance and Economics Discussion Series 2004-06, Board of Governors of the Federal Reserve System (U.S.).
  17. Verrecchia, Robert E, 1982. "Information Acquisition in a Noisy Rational Expectations Economy," Econometrica, Econometric Society, vol. 50(6), pages 1415-30, November.
  18. Maria Demertzis & Marco Hoeberichts, 2006. "The Costs of Increasing Transparency," DNB Working Papers 080, Netherlands Central Bank, Research Department.
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Cited by:
  1. M. Middeldorp & S. Rosenkranz, 2008. "Information acquisition in an experimental asset market," Working Papers 08-25, Utrecht School of Economics.
  2. M. Middeldorp & S. Rosenkranz, 2008. "Central bank communication and crowding out of private information in an experimental asset market," Working Papers 08-26, Utrecht School of Economics.

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