Monetary Policy, Endogenous Inattention, and the Volatility Trade-Off
56 Pages Posted: 31 Oct 2007
Date Written: December 2004
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.
Keywords: expectations, optimal monetary policy, bounded rationality, economic stability, adaptive learning
JEL Classification: E52, E31, D83, D84
Suggested Citation: Suggested Citation
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