Central bank transparency under the cost channel

• DOI: http://doi.org/10.1111/infi.12107
• Author: Qiao Zhang,Meixing Dai
• Date: 01 June 2017
• Published date: 01 June 2017

DOI: 10.1111/infi.12107

ARTICLE

Central bank transparency under the cost channel

Meixing Dai

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Qiao Zhang

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Université de Strasbourg, CNRS, BETA

UMR 7522, Strasbourg Cedex, France

2

Université de Lorraine, CNRS, BETA

UMR 7522, Nancy, France

Correspondence

Meixing Dai, Université de Strasbourg,

CNRS, BETA UMR 7522, 61, avenue de

la Forêt Noire, 67085 Strasbourg Cedex,

France.

Email: dai@unistra.fr

Abstract

This paper studies the implications of information disclo-

sure about the central bank’s preferences regarding inflation

and output-gap stabilization in the presence of the cost

channel of monetary transmission. Through this channel,

higher interest rates translate into higher marginal costs of

production and, finally, into higher inflation. Conventional

wisdom has it that whether the central bank is transparent

alters the effects of cost-push or supply shocks, but does not

change the fact that demand shocks are fully offset by

optimal monetary policy. We show that this view is

incorrect in the presence of a cost channel, since the latter

not only affects how transparency interacts with cost-push

shocks, but also makes it interact with demand shocks.

Moreover, the desirability of full transparency when shocks

are persistent is significantly reduced by the presence of the

cost channel.

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INTRODUCTION

The trend for central banks to become more transparent began more than two decades ago and survived

the onset of the global financial crisis (Dincer & Eichengreen, 2014). This is because central bank

transparency helps the public understand monetary policy. Better public understanding enhances

accountability and thus public support for central bank independence, enables markets to respond more

smoothly to policy decisions, and makes policy decisions more credible and effective.

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Although

central banks adopt increasingly high standards of transparency in their communications, they

disseminate relatively little information about the preference weights assigned to inflation and output

stabilization in their loss function (Cukierman, 2009).

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This cautious approach to political transparency

regarding preference weights reflects both its importance compared to other motives of central bank

transparency and the lack of consensus about its macroeconomic effects.

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International Finance. 2017;20:189–209. wileyonlinelibrary.com/journal/infi © 2017 John Wiley & Sons Ltd

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The literature on optimal monetary policy posits that a central bank, in its effort to stabilize inflation and

output, should set policy to strike a balance between the costs of inflation and output variability.The higher the

relative preference weight put on output stabilization, the longer it will take the central bank to revert inflation

to its target. This is why information disclosure about preference weights is essential for private agents to

evaluate the speed at which the central bank plans to steer the economy back to equilibrium following cost-

push shocks that affect cost of production factors. Notice that in standard macroeconomic models, demand

shocks are fully counteracted by optimal monetary policy, regardless of preference weights.

Whether the effectiveness of monetary policy is improved or impaired by public disclosure of

preference weights is a controversial issue. In the Barro-Gordon framework, transparency about

preference weights improves macroeconomic stabilization and is beneficial to social welfare (Beetsma

& Jensen, 2003; Demertzis & Hughes Hallet, 2007, 2015; Eijffinger, Hoeberichts, & Schaling, 2000;

Faust & Svensson, 2001; Nolan & Schaling, 1998). In contrast, opacity could be the best choice of the

central bank in models with distortions due to the wage-setting behavior of labor unions (Grüner, 2002;

Sørensen, 1991; Spyromitros & Zimmer, 2009), distortionary taxes, or public investment (Ciccarone,

Marchetti, & Di Bartolomeo, 2007; Dai & Sidiropoulos, 2011; Hughes-Hallett & Viegi, 2003). In the

standard New Keynesian model characterized by monopolistic competition, opacity could also be

justified when cost-push shocks are persistent (Dai, 2016). The ‘theory of the second-best’suggests

that the removal of one distortion may not always yield a more efficient allocation when other

distortions are present. In accordance with this theory, opacity regarding preference weights creates a

distortion that could improve social welfare because it would discipline the private sector and the

government in their decisions. Despite their differences, the aforementioned studies share a common

result: that is, varying the degree of transparency about preference weights only affects the effects of

cost-push shocks but does not change the fact that demand shocks are fully offset.

This paper aims to show that this common result should be amended when the New Keynesian model is

extended to account for the cost channel of monetary transmission. The latter describes the effect of a

change in the policy interest rate on the funding costs of the working capital of firms and hence on the

aggregate supply. The presence of this channel implies that it is no longer optimal for the central bank to

fully offset demand shocks. Our main findings are that: (i) the cost channel allows demand shocks to

interact, to a lesser-but-still-significant extent, with transparency as cost-push shocks; (ii) it generally

reinforces the amplification (attenuation) effect of heightened transparency on the average and volatility of

inflation (the output gap) in the presence of serially correlated cost-push shocks; and (iii) it considerably

reduces the threshold for the degree of shock persistence above which full transparency is not optimal.

The New Keynesian model withthe cost channel used in this paper is a simplified version of the one

built by Ravenna and Walsh (2006). One way to motivate the cost channelis to assume that firms hold

working capital.To the extent that firms must pay the factors of productionbefore they receive revenues

from sellingtheir products, firms need to borrow funds from banks to pre-financetheir production (Barth

& Ramey, 2001; Christiano & Eichenbaum, 1992).

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Higher nominal interest rates raise the marginal

costs of production and eventually inflation. Therefore, a monetary policy decision in response to

demand shocks also affects the supply. The central bank can no longer fully offset demand shocks by

optimally setting its policy interest rate, meaning that demand shocks generate a trade-off between

inflationand output-gap stabilization as cost-pushshocks. The cost channel couldhave important overall

impactson the effect of transparency because, on the one hand, it amplifiesthe effect of cost-push shocks;

on the other hand, demand shocks could explain a large part of short-run price and output fluctuations

(Blanchard & Quah, 1989; Dufourt, 2005). The conclusions reached by our paper on the effect of

transparency therefore enrich the existing literature on monetary policy with the cost channel.

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The transmission mechanism of monetary policy int hispaper is similar, except for the cost channel, to the

one in the standard New Keynesian model (Clarida, Gali, & Gertler, 1999). In the standard New Keynesian

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DAI AND ZHANG