Monetary policy and aggregate volatility

Discretionary conduct of monetary stabilization policy can increase real and nominal aggregate volatility by arbitrary amounts when firms pay limited attention to aggregate shocks. A conservative central banker with stronger preference for price stability eliminates the commitment problem, thereby reduces output and price volatility and gives rise to a policy-induced 'Great Moderation'. Increased focus on price stability facilitates firms' information processing and aligns their expectations better with policy decisions. This 'coordination effect' reduces aggregate real and nominal volatility. Consistent with empirical evidence, the moderation manifests itself through reduced residual variance in vector autoregressions (VARs) involving macroeconomic variables. (C) 2009 Elsevier B.V. All rights reserved.