Optimal communication policy

Monetary policy as a tool for expectations management is believed to be most effective if it can coordinate the beliefs and expectations of the economic agents. The optimal communication policy is in an environment where central bank announcements are common knowledge and abundant information is complete transparency. The above conclusion is altered in the more realistic situation where economic agents face uncertainty regarding underlying economic fundamentals combined with strategic complementarity between player’s actions. The optimal communication policy in a case with imperfect common knowledge is incomplete transparency or a degree of opacity. Uncertainty about the underlying economic state in the presence of strategic complementarity is the origin for the emergence of imperfect common knowledge. We further develop these issues in the context of a Lucas-island model. Full policy transparency in this setting leads to an economic distortion residing in a wedge between economic agent’s expectations and optimal fundamental-based allocations—dubbed as over-reaction to the central bank announcements. JEL Classifications: E50, E58, E59, G11, G12, G13, G14