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

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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File URL: http://dspace.library.uu.nl/bitstream/handle/1874/31467/07-19.pdf
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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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  1. 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.
  2. 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.
  3. Tabellini, Guido, 1987. "Secrecy of Monetary Policy and the Variability of Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 19(4), pages 425-36, November.
  4. Michael Woodford, 2005. "Central bank communication and policy effectiveness," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, issue Aug, pages 399-474.
  5. 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.).
  6. 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.
  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. 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.
  9. Svensson, Lars O & Tetlow, Robert J, 2005. "Optimal Policy Projections," MPRA Paper 839, University Library of Munich, Germany.
  10. Demertzis, Maria & Andrew Hughes Hallett, 2003. "Central Bank Transparency in Theory and Practice," Royal Economic Society Annual Conference 2003 56, Royal Economic Society.
  11. Wolfers, Justin & Zitzewitz, Eric, 2006. "Prediction Markets in Theory and Practice," CEPR Discussion Papers 5578, C.E.P.R. Discussion Papers.
  12. Athanasios Orphanides & John C. Williams, 2003. "Inflation scares and forecast-based monetary policy," Working Paper 2003-21, Federal Reserve Bank of Atlanta.
  13. Maria Demertzis & Marco Hoeberichts, 2006. "The Costs of Increasing Transparency," DNB Working Papers 080, Netherlands Central Bank, Research Department.
  14. Marvin Goodfriend, 1985. "Monetary mystique : secrecy and central banking," Working Paper 85-07, Federal Reserve Bank of Richmond.
  15. Verrecchia, Robert E, 1982. "Information Acquisition in a Noisy Rational Expectations Economy," Econometrica, Econometric Society, vol. 50(6), pages 1415-30, November.
  16. Diamond, Douglas W, 1985. " Optimal Release of Information by Firms," Journal of Finance, American Finance Association, vol. 40(4), pages 1071-94, September.
  17. Stephen Morris & Hyun Song Shin, 2002. "Social Value of Public Information," American Economic Review, American Economic Association, vol. 92(5), pages 1521-1534, December.
  18. Verrecchia, Robert E., 2001. "Essays on disclosure," Journal of Accounting and Economics, Elsevier, vol. 32(1-3), pages 97-180, December.
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