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

Listed author(s):
  • William A. Branch
  • Charles T. Carlstrom
  • George W. Evans
  • Bruce McGough

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.

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Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 0411.

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Date of creation: 2004
Handle: RePEc:fip:fedcwp:0411
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