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Monetary policy, endogenous inattention, and the volatility trade-off

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  • William A. Branch
  • John B. Carlson
  • George W. Evans
  • Bruce McGough

Abstract

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.

Suggested Citation

  • William A. Branch & John B. Carlson & George W. Evans & Bruce McGough, 2004. "Monetary policy, endogenous inattention, and the volatility trade-off," Working Papers (Old Series) 0411, Federal Reserve Bank of Cleveland.
  • Handle: RePEc:fip:fedcwp:0411
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    Cited by:

    1. Paul Hubert & Giovanni Ricco, 2018. "Imperfect Information in Macroeconomics," Revue de l'OFCE, Presses de Sciences-Po, vol. 0(3), pages 181-196.
    2. Gaballo, Gaetano, 2013. "Good luck or good policy? An expectational theory of macro volatility switches," Journal of Economic Dynamics and Control, Elsevier, vol. 37(12), pages 2755-2770.
    3. William Branch & George W. Evans, 2007. "Model Uncertainty and Endogenous Volatility," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 10(2), pages 207-237, April.
    4. Pfajfar, Damjan, 2013. "Formation of rationally heterogeneous expectations," Journal of Economic Dynamics and Control, Elsevier, vol. 37(8), pages 1434-1452.
    5. William A. Branch & John B. Carlson & George W. Evans & Bruce McGough, 2006. "Adaptive learning, endogenous inattention, and changes in monetary policy," Working Papers (Old Series) 0610, Federal Reserve Bank of Cleveland.
    6. N. Gregory Mankiw & Ricardo Reis, 2002. "Sticky Information versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve," The Quarterly Journal of Economics, Oxford University Press, vol. 117(4), pages 1295-1328.
    7. Milani, Fabio, 2008. "Learning, monetary policy rules, and macroeconomic stability," Journal of Economic Dynamics and Control, Elsevier, vol. 32(10), pages 3148-3165, October.
    8. Hommes, Cars & Massaro, Domenico & Weber, Matthias, 2019. "Monetary policy under behavioral expectations: Theory and experiment," European Economic Review, Elsevier, vol. 118(C), pages 193-212.
    9. Ricardo Reis, 2009. "Optimal Monetary Policy Rules in an Estimated Sticky-Information Model," American Economic Journal: Macroeconomics, American Economic Association, vol. 1(2), pages 1-28, July.
    10. Yingying Xu & Zhixin Liu & Zichao Jia & Chi-Wei Su, 2017. "Is time-variant information stickiness state-dependent?," Portuguese Economic Journal, Springer;Instituto Superior de Economia e Gestao, vol. 16(3), pages 169-187, December.
    11. Lena Draeger, 2011. "Endogenous persistence with recursive inattentiveness," KOF Working papers 11-285, KOF Swiss Economic Institute, ETH Zurich.
    12. Orland, Andreas & Roos, Michael W.M., 2019. "Price-setting with quadratic adjustment costs: Experimental evidence," Journal of Economic Behavior & Organization, Elsevier, vol. 163(C), pages 88-116.
    13. Milani, Fabio, 2007. "Expectations, learning and macroeconomic persistence," Journal of Monetary Economics, Elsevier, vol. 54(7), pages 2065-2082, October.
    14. Kwangyong Park, 2019. "Uncertainty, Attention Allocation and Monetary Policy Asymmetry," Working Papers 2019-5, Economic Research Institute, Bank of Korea.
    15. Efrem Castelnuovo, 2006. "Monetary Policy Switch, the Taylor Curve, and the Great Moderation," Computing in Economics and Finance 2006 59, Society for Computational Economics.
    16. George W. Evans & Seppo Honkapohja, 2009. "Expectations, Learning and Monetary Policy: An Overview of Recent Research," Central Banking, Analysis, and Economic Policies Book Series, in: Klaus Schmidt-Hebbel & Carl E. Walsh & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series (ed.),Monetary Policy under Uncertainty and Learning, edition 1, volume 13, chapter 2, pages 027-076, Central Bank of Chile.
    17. N. Gregory Mankiw & Ricardo Reis, 2007. "Sticky Information in General Equilibrium," Journal of the European Economic Association, MIT Press, vol. 5(2-3), pages 603-613, 04-05.
    18. Martin Ellison & Tony Yates, 2007. "Escaping Volatile Inflation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(4), pages 981-993, June.
    19. Carola Conces Binder, 2021. "Central Bank Communication and Disagreement about the Natural Rate Hypothesis," International Journal of Central Banking, International Journal of Central Banking, vol. 17(2), pages 81-123, June.
    20. Alberto Locarno, 2007. "Imperfect Knowledge, Adaptive Learning, and the Bias Against Activist Monetary Policies," International Journal of Central Banking, International Journal of Central Banking, vol. 3(3), pages 47-85, September.
    21. Hahn, Volker, 2014. "Transparency In Monetary Policy, Signaling, And Heterogeneous Information," Macroeconomic Dynamics, Cambridge University Press, vol. 18(2), pages 369-394, March.

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    More about this item

    Keywords

    Monetary policy; Inflation (Finance);

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness

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