Monetary Stabilization of a Multi-Sector Economy: Adding Words to Action?

Strategic communication, reputation and long-run welfare

Recent economic shocks — from the COVID-19 pandemic to energy price surges and global supply chain disruptions — have underscored that different sectors of the economy are affected unevenly. This asymmetry creates challenging trade-offs for central banks: with only one primary policy tool — the interest rate — it is impossible to perfectly offset sector-specific shocks and ensure that prices across all sectors adjust efficiently.

This paper extends the classical analyses of time inconsistency in monetary policy—for example, as studied by Barro and Gordon (1983) and Barro (1986)— and asks whether central banks can enhance economic stabilization by using another instrument in their toolkit: communication. Modern central banks are not merely interest-rate setters; they also regularly communicate their assessments of the economy and the future path of policy. Importantly, they often have access to richer information than private firms — drawing on a broad range of data sources and analytical expertise. Several influential empirical studies show that central bank announcements significantly influence how markets and firms update their expectations, a mechanism known as the information effect of monetary policy. 

The analysis is formalized in a theoretical model of a multi-sector economy, in which each sector is subject to its own productivity shocks and price-setting frictions. In such an environment, monetary policy faces the challenge of stabilizing the economy with a single instrument that cannot simultaneously target all sectors. To explore the potential contribution of communication to economic stabilization, we introduce an information asymmetry between the central bank and price-setting firms: the central bank observes signals about sector-specific economic conditions that firms cannot fully discern. This asymmetry makes communication a potential valuable tool for guiding firms’ pricing decisions and enhancing overall stabilization outcomes.
Our study first offers a normative answer: in an ideal world where the central bank can credibly commit to a state-contingent communication rule—i.e., a policy that prescribes what information to reveal depending on the state of the economy and the distribution of shocks across sectors—the optimal communication rule is to disclose this private information truthfully and transparently.  This helps firms adjust their prices in line with sector-specific developments, though it may still leave price dispersion across firms and sectors. However, a central bank may be tempted to adjust its disclosures, especially if withholding or shading information could reduce undesirable price differences in the short term. This temptation implies that truthful and complete communication is not always fully credible.

To explore this tension, we relax the commitment assumption and develop a positive analysis of how a central bank’s reputation interacts with its communication strategy. In our framework, firms are uncertain whether the central bank always tells the truth or sometimes strategically distorts information. A central bank that acts strategically may achieve short-term gains by stabilizing prices more effectively (Figure 1 – panel b) — but at the costs of eroding its reputation for truthfulness. Over time, this reputational decline makes its communication less effective and leads to worse economic outcomes compared to a scenario where information is consistently truthful and credible (Figure 1 – panel a).

In short, our findings highlight a key trade-off: while strategic communication may yield short-term welfare benefits, it may undermine trust and weakens the effectiveness of monetary policy over time, ultimately harming economic stability in a multi-sector economy.

Keywords: Strategic Communication, Monetary Policy, Credibility, Reputation, Bayesian Learning

Codes JEL : D82, E52, E58, E61