Communication, Coordination and Common Knowledge in Monetary Policy

Abstract

This paper develops and tests a model which suggests that coordination of wage bargaining and transparency of central bank procedures are two alternative mechanisms that can increase the speed with which expectations adjust to changes in central bank policy. I consider this for an economy where actions of individual wage earners depend on ‘higher order beliefs’ — expectations of what the ‘average’ wage setter believes about the economy. In this context, when central banks change policies they face a problem not only of convincing each individual member of the public that a change has occurred; they also need to ensure that the policy change becomes common knowledge. Decisions by central banks to publish their economic forecasts or records of deliberations and efforts by wage bargainers to coordinate their activities and pool private information can both increase the speed with which higher order beliefs adjust to a policy change. I test these propositions by considering output-inflation tradeoffs in the 1990s for 21 OECD economies. The theoretical predictions of this paper and supporting empirical results suggest that in a euro zone that lacks centralized wage bargaining institutions there may be significant benefits from central bank transparency.