“The Great Moderation: What Caused It and Is It Over?” by James Morley in Macro Focus, December 2009, Vol. 4, No. 8, pp.

1. “The Great Moderation: What Caused It and Is It Over?”by James MorleyinMacro Focus,December 2009, Vol. 4, No. 8, pp. 1 - 11 Presented by: Professor Yamin Ahmad

2. Key Questions Addressed in the Paper • What was the Great Moderation and did it occur? • Some evidence of the Great Moderation • What are some explanations for the Great Moderation? • Nature of shocks

3. Main Findings • Great Moderation did occur:- • There was a decline in US Macroeconomic volatility since the mid 1980’s. • Reduction in volatility did not primarily come about because of better macroeconomic policy, or because of the way the economy responds to shocks changed in any significant manner. • The Great Moderation appears to have been mostly caused by smaller economic shocks

4. Outline of the Presentation • Definition of the Great Moderation • Causes of the Great Moderation • Significance of Shocks • Summary and Conclusions

5. Great Moderation • Ben Bernanke: • “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” (2004) • Kim and Nelson (1999) and Perez-Quiros (2000) found evidence of a large reduction in the volatility of US real GDP growth over the past half-century. • Both papers found that the reduction was sudden and estimated to have occurred in 1984Q1.

6. The Great Moderation 1984Q1

7. Reduction in Volatility • Annualized growth rates fluctuated between numbers like -5% to +10% before the moderation. • Post moderation, they line up closely to the long term growth rate of 3.3%. • Note: This was not simply because of longer expansions and shorter recessions. Volatility decreased for both!

8. 1984 Quarter 1 • Question: What is special about 1984Q1? • Answer: Nothing! • At least nothing that would lead economists a priori to expect a fundamental change in the behavior of aggregate output growth. • Moreover, Stock and Watson (2003) found that other countries experienced something similar, although not at exactly the same point in time.

9. Causes of the Great Moderation • Ben Bernanke highlighted three possibilities in his 2004 speech: • Better macroeconomic policy • Changed economic structure • “Good Luck”

10. 1. Better Policy • The idea that better policy led to the Great Moderation arises from the timing of policy (in particular monetary policy) and then the subsequent decline in volatility that was seen • For the US: Paul Volcker’s disinflationary policy lowered inflation by 1984 and an economic recovery followed subsequently. • Clarida, Gali and Gertler (2000) have also argued that the Fed, by following the “Taylor Principle” managed to stabilize inflation, and through the Phillips Curve, managed to stabilize output.

11. 1. Better Policy (cont.) • Morley (2009) argues that inflation expectations were brought down during the Volcker and Greenspan years, and that part is consistent with Clarida, Gali and Gertler (2000) have argued. • However, he argues that their explanation does not manage to explain the high output volatility prior to the 1970s. • On the international front, the stabilization of output growth in Canada and the UK broadly coincides with the countries adopting inflation targeting, which helped to pin down inflation expectations.

12. 2. Changed Economic Structure • Stabilization of output growth due to: • Globalization: international trade would lead to a greater diversification of sources of demand, so domestic business cycles should have a less pronounced effect on output. • Improvements in financial intermediation, due to globalization of finance • In the academic literature, globalization story didn’t receive much attention because of a lack of evidence to support it. • Inventory management is main structural story since output growth volatility appears to have declined by more than the volatility of final sales

13. 3. Good Luck • Many empirical economists have instead argued for the “good luck” story • Whilst we would like to say that the Great Moderation occurred because of better policy or because of structural improvements in things like inventory leading to a more stable response of the economy to shocks … • …they find that the evidence from looking at the dynamic response of the economy to shocks is weak.

14. 3. Good Luck (cont.) • Empirical macroeconomists have run “counterfactual experiments” where they have mixed economic shocks from one sample period (e.g. pre-moderation period) with the estimated dynamic responses of output and other variables from another sample period (e.g. post-moderation period) • They used “Vector Autoregressions” or VARs to examine the dynamics and find that using those shocks, the post-moderation dynamics yielded output growth that was just as volatile as during the pre-moderation period. • Also doing the opposite (using post-moderation shocks and examining the dynamics of output in the pre-moderation period) yielded output volatility similar to that in the post-moderation period.

15. 3. Good Luck (cont.) • For example, Kim, Morley and Piger (2008) found that the estimated standard deviation of output growth dropped from 4.7% to 2.3% with the Great Moderation. • In the counterfactual based on pre-moderation shocks and post-moderation dynamics, the standard deviation was 5.0% • In the counterfactual based on post-moderation shocks and pre-moderation dynamics, the standard deviation was 2.3%.

16. Ben Bernanke • In his 2004 speech: • “My view is that improvements in monetary policy, though certainly not the only factor, have probably been an important source of the Great Moderation. In particular, I am not convinced that the decline of macroeconomic volatility of the past two decades was primarily the result of good luck.” • Policy can do more subtle things than simply stabilize output to shocks. It can influence inflation expectations, and hence by providing that anchor, can help to reduce the additional volatility in output that may have arisen from changing inflation expectations (… “sunspot shocks” …).

17. Ben Bernanke • He goes on to say: • “Notably, if the Great Moderation was largely the result of good luck rather than a more stable economy or better policies, then we have no particular reason to expect the relatively benign economic environment of the past twenty years to continue.”

18. Which Economic Shocks Mattered • The good luck hypothesis represents a mixture of different kinds of smaller economic shocks: • Policy and financial shocks: appear to have played a minor role in reducing volatility. • Oil shocks (supply side): have been large at certain points in time (e.g. 1974, 1979), and the reduction in the size of these shocks are thought to have played some role in volatility reduction. • Productivity shocks and inventory mistakes: these appear to have played the biggest role in the Great Moderation.

19. Is the Great Moderation Over? • It is too soon to know if there is has been a permanent increase in volatility since the Great Recession (… something that we refer to as a structural break …). • If oil prices, productivity and inventories explains a great portion of what led to the Great Moderation, then Morley claims that it is unlikely to be over.