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Monetary Policy, Endogenous Inattention, and the Volatility Trade-off

  • Wiliam Branch

    (University of Californis - Irvine)

  • John Carlson

    (Federal Reserve Bank of Cleveland)

  • George W. Evans

    ()

    (University of Oregon Economics Department)

  • Bruce McGough

    (Oregon State University)

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 1980's.

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Paper provided by University of Oregon Economics Department in its series University of Oregon Economics Department Working Papers with number 2004-19.

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Length: 52
Date of creation: 07 Dec 2004
Date of revision: 15 May 2007
Handle: RePEc:ore:uoecwp:2004-19
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