How Much Information should Interest Rate-Setting Central Banks Reveal?
Morris and Shin (2002) have shown that a central bank may be too transparent if the private sector pays too much attention to its possible imprecise signals simply because they are common knowledge. In their model, the central bank faces a binary choice: to reveal or not to reveal its information. This paper extends their model to the more realistic case where the central bank must anyway convey some information by setting the interest rate. This situation radically changes the conclusions. In many cases, full transparency is socially optimal. In other instances the central bank can distill information to either manipulate private sector expectations in a way that reduces the common knowledge effect or to reduce the unavoidable information content of the interest rate. In no circumstance is the option of only setting the interest rate socially optimal.
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