Monetary Policy, Endogenous Inattention, and the Output-Inflation Variance Tradeoff

Many models of monetary policy predict a trade-off between inflation and output variance despite compelling evidence that the Federal Reserve has become more aggressive in fighting inflation and there has been a resulting decline in both inflation and output variance. We address this apparent puzzle by studying the interaction of optimal monetary policy and agents' beliefs. Following (Ball, Mankiw, and Reis 2003) we depart from the Rational Expectations hypothesis and instead posit that there is costly information gathering. We assume that agents choose the rate at which they acquire new information by minimizing a quadratic loss subject to a linear cost function increasing in the rate of information accrual. We show that the solution to this minimization problem depends on the choices of other agents in the economy. Endogenous inattention is a Nash equilibrium in the rate of information processing. We show that multiple equilibria abound. Moreover, there is a non-monotonic trade-off between inflation and output variance, so that if policy is sufficiently `hawkish' against inflation, both inflation and output variance are positively related.