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

56 Pages Posted: 31 Oct 2007

See all articles by William Branch

William Branch

University of California, Irvine - Department of Economics

John B. Carlson

Federal Reserve Bank of Cleveland

George W. Evans

University of Oregon - Department of Economics; University of St. Andrews - School of Economics and Finance

Bruce McGough

Oregon State University - Department of Economics

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

Branch, William and Carlson, John B. and Evans, George W. and McGough, Bruce, Monetary Policy, Endogenous Inattention, and the Volatility Trade-Off (December 2004). FRB of Cleveland Working Paper No. 04-11, Available at SSRN: https://ssrn.com/abstract=1025596 or http://dx.doi.org/10.2139/ssrn.1025596

William Branch

University of California, Irvine - Department of Economics ( email )

3151 Social Science Plaza
Irvine, CA 92697-5100
United States
757-221-2432 (Phone)

John B. Carlson (Contact Author)

Federal Reserve Bank of Cleveland ( email )

PO Box 6387
Cleveland, OH 44101-1387
United States

George W. Evans

University of Oregon - Department of Economics ( email )

1285 University of Oregon
Eugene, OR 97403
United States
541-346-4662 (Phone)
541-346-1243 (Fax)

University of St. Andrews - School of Economics and Finance ( email )

The Scores, Castlecliff
St. Andrews, Fife KY16 8RD
United Kingdom
44-1334-462435 (Phone)

HOME PAGE: http://www.st-andrews.ac.uk/economics/staff/pages.g.evans.shtml

Bruce McGough

Oregon State University - Department of Economics ( email )

303 Ballard Extension Hall
Corvallis, OR 97331
United States
541-737-2321 (Phone)
541-737-5917 (Fax)

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