"The Great Moderation: What Caused It and Is It Over?"

The paper below says that, contrary to what you might think, the Great Moderation is not over. What is the Great Moderation? From the paper:

The idea of “the Great Moderation” came to widespread public attention in a 2004 speech by then-Federal Reserve Governor Ben Bernanke.1 He began his speech with a statement of empirical fact: “One of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility.”

This empirical fact was established in two influential academic papers by Kim and Nelson (1999) and McConnell and Perez-Quiros (2000).2 Both papers presented evidence of a large reduction in the volatility of U.S. real GDP growth over the past half-century. Furthermore, both papers found that the reduction was sudden and estimated to have occurred in 1984Q1.

This sudden reduction in volatility is visible to the naked eye in Figure 1, which plots seasonally-adjusted quarterly U.S. real GDP growth for the period of 1947Q2-2009Q3.

Let me repeat a list of factors from a previous post that have been proposed to explain the Great Moderation:

• Better technology, e.g. information processing allowing better inventory control and management
• Better policy, e.g. inflation targeting
• Good luck so that no big shocks hit the economy
• Financial innovation and deregulation
• Globalization leading to dispersed risk
• Better business practices (this is less common, here's the link)
• Increased rationality of participants in financial markets
• Demographic shifts (again, since this less commonly offered as an explanation, here's the link)

Much of the literature prior to the crisis found that monetary policy was at least a contributing factor, if not the major factor behind this change (e.g. empirical evidence from Clarida, Gali, and Gertler of a large increase in the coefficient on inflation in the Taylor rule that, in New Keynesian models, would lead to a more stable economy). However, this paper focuses on the "good luck" explanation and finds that "smaller economic shocks related to oil prices, productivity, and inventories explain much of the Great Moderation." In addition, the paper finds that our good fortune may not be over:

The Great Moderation: What Caused It and Is It Over?, by James Morley: In this Macro Focus, our resident time series econometrician, James Morley, tries to rehabilitate the “Great Moderation.” His findings are both surprising and encouraging:

• Contrary to conventional wisdom, the Great Moderation was not a myth. There has been a very real, broad-based decline in U.S. macroeconomic volatility since the mid-1980s.

• The reduction in volatility does not appear to be primarily the result of better policy or changes in the structural response of the economy to shocks.

• Instead, the Great Moderation appears to be mostly due to smaller economic shocks (e.g., oil price shocks, productivity shocks, and inventory mistakes).

• The technological basis for the smaller shocks means that the prognosis for the continuation of the Great Moderation is much better than you might think.

Given the financial and economic turmoil of the past few years, it would be easy to believe the “Great Moderation” was a myth based on wishful thinking. Many commentators have proclaimed as much and even many of us who study the phenomenon have started to wonder whether it was all too good to be true.

Despite these doubts, a dispassionate examination of the data suggests that the stabilization of economic activity since the mid-1980s was very much a reality. The more legitimate question is whether or not it is now over. This Macro Focus seeks to answer this question through careful analysis of what caused the Great Moderation. The finding that it was largely due to smaller economic shocks for technological reasons implies a surprisingly optimistic prognosis for its continuation. ... [paper]