Over-reaction to Policy Signals, and Central Bank Optimal Communication Policy

Abstract

Abstract This paper reviews the theoretical arguments and counter arguments regarding central bank optimal communication policy in an environment with imperfect common knowledge and strategic complementarity. More specifically, the paper discusses the environment in which full transparency is no longer necessarily the superior strategy. Uncertainty about the underlying economic state in the presence of dispersed information is the basis for the emergence of imperfect common knowledge. These issues are further discussed in an augmented Lucas-island model. Full policy transparency in this setting leads to overreliance to central bank public policy signals, resulting in the expectations coordination away from fundamentals - dubbed as over-reaction to central bank announcements. Optimal communication policy in this context entails strategies to limit over-reaction via partial transparency or partial publicity.