Monetary Policy, Endogenous Inattention, and the Volatility Trade-off
This paper addresses the output-price volatility puzzle by studying the interaction of optimal monetary policy and agents’ beliefs. We assume that agents choose their information acquisition rate by minimizing a loss function that depends on expected forecast errors and information costs. Endogenous inattention is a Nash equilibrium in the information processing rate. Although a decline of policy activism directly increases output volatility, it indirectly anchors expectations, which decreases output volatility. If the indirect effect dominates then the usual trade-off between output and price volatility breaks down. This provides a potential explanation for the "great moderation" that began in the 1980s.
JEL Classification: E52; E31; D83; D84
Key Words: expectations, optimal monetary policy, bounded rationality, economic stability, adaptive learning.
Suggested citation: Branch, William, John Carlson, George Evans, and Bruce McGough, 2004. "Monetary Policy, Endogenous Inattention, and the Volatility Trade-off," Federal Reserve Bank of Cleveland, Working Paper no. 04-11.