Monetary Policy and the Great Moderation Monetary Policy and the Great Moderation

Increased focus on price stability by a discretionary central bank reduces output and price volatility in a model with rationally inattentive …rms. The volatility reduction can be arbitrarily large, e.g., imply a 'Great Moderation', and is particularly pronounced when …rms can process information almost perfectly. The model-implied vector auto-regressive (VAR) dynamics are consistent with the empirical observation that the dynamics before and after the Great Moderation di¤er mainly with respect to the variance of the VAR residuals. These results emerge in the model because increased focus on price stability by the central bank facilitates …rms'information processing problem, thereby aligns expectations better with policy decisions. This reduces aggregate real and nominal volatility.