Introduction
The Great Moderation is a period characterized by a decreasing trend in aggregate volatility of the economy experienced in the U.S. since the mid 1980s. At the beginning of the Great Moderation, the variability of quarterly real GDP decreased by half (from 5.4 percent in 1980 to 2.1 in 1986). At the same time, the variability of the quarterly inflation reduced by two thirds measured in standard deviation.
For the past 25 years the U.S. has enjoyed less instability of the economy than the prior years. However, this was interrupted by the 1990-91 and 2001 recessions. Although it has been difficult to decisively pin-point the causes of decreased volatility, structural changes, improved monetary policy and economic good luck (lesser shocks) have been attributed to it. Majority of policy makers and economists viewed the Great Moderation to have high probability of being permanent.
Most recently, the harshness of the 2007-09 recession led to some economists argue that the Great Moderation is dead. However, such a deep recession does not necessarily mean it is over. It depends on the cause of the recession. Over time, volatility is likely to undergo irregular shifts linking high and low levels. The low volatility is the norm. This debate about whether the Great moderation is dead or alive can be settled by: Looking into the cause of the Great moderation and questioning whether it ended with the deep recession.
The Key Macroeconomic facts
Changes in GDP growth have become more hushed in the past 25 years. As from 1960 to early 1980s the U.S. quarterly GDP growth rate was experienced as high as 15 percent and as low as -8 percent. At the start of 1984 the variability of the GDP was a bit lower indicating higher stability of the economy. Apart from the GDP, the higher stability of the economy has also impacted on: Consumption, investment, labor productivity, the stock market and total factor productivity. The factors have had almost equal stabilization except for the stock market that has not stabilized considerably. The fall in aggregate volatility has not only been felt in the U.S. but also in other countries, both developed and developing. The reduced volatility was experienced in during the period 1984-2007.
In the recent, recession has created sharp decreases in GDP growth rate. On estimation, growth rate in 2008 and quarter one of 2009 plummeted to -6 percent. The changes in GDP growth indicate an increase in volatility to the level experienced prior the Great Moderation (1961-1983). Statistical estimates indicate reversal of much of the Great Moderation. Volatility has increased due to bigger variability in the economy. The explanation for this greater variability include: huge shocks to oil prices, housing sector, and financial markets. The high volatility in the recent, which is after 2007, has raised questions whether the Great moderation is over or not.
The Key Microeconomic facts
Although the aggregate economy has become more stable, generally, the profits, sales and employment of individual publicly – traded companies have become more volatile. This difference has occurred because individual firms are steered by firm specific factors. For instance, a firm’s gain is another one’s loss because of competition resulting into gaining a new market or losing their own market. Therefore, the impact of high competition on the volatility of aggregate production is less. Thus, firm specific factors can lead to in firm volatility without impacting on the aggregate volatility.
Minor, non public companies have had a decrease in volatility but this cannot be attributed to the decline in aggregate volatility. Firm specific factors play a bigger role in explaining volatility in small companies than bigger ones. Aggregate measures of the economy like GDP are not influenced by firm specific factors. Therefore, changes in firm specific factors that steer the volatility of both companies are unrelated aggregate volatility determinants. Those factors which influence the correlation of firms in their performance contribute to aggregate volatility. When firms are more independent the GDP is more stable and vice versa.
Firm level volatility is used to explain the reason as to why the Great moderation is felt by majority of the people in their lives. Despite the decline of aggregate volatility, volatility of earnings of average U.S. workers has been on the rise since 1970s. Fortunes of large companies have turned to be more volatile. This has caused compensation schemes which condition wages on firm performance to transformed into high earnings volatility. This has contributed to the high wage variability experienced in the U.S. during the past three decades despite the Great Moderation.
The Main Factors responsible for the great moderation
Much of the research on the factors that are responsible for the Great Moderation reflect on structural changes in the economy, better monetary policy and good luck. Very crucial structural changes comprise better inventory management and financial innovations. For instance just in time inventory technique introduced in the 1970s allowed for better control of stock hence reduced disruptions in production. Also eradication of ceilings on interest rates on bank deposits aided in stabilization of funds to lenders and then, in turn, borrowers.
According to Bernanke (2004), in the late 1960s and early 1970s, policymakers eased monetary policy to encourage the economy and attain high economic activity, which increased inflation. Policymakers then tightened policy to reduce inflation which caused a sharp contraction of the economic situation. The policy was eased and the cycle began again. By 1980smoney policy’s response to inflation was more appropriate and aided in stabilizing the economy (Bernanke, 2004)
Another factor explaining the Great moderation is the “good luck” hypothesis. Accordingly, it is observed that the economy was very volatile from 1960s to early 1980s. This was attributed to unusually large shocks like oil prices. From 1980s to until recently, the economy has been luck. This is because of the smaller shocks hence less variability of the economy.
In spite of the considerate research, extensive agreement on the factors that are responsible for the Great moderation remains a difficult objective to achieve. Even though, different research backs up each of the explanations. Greenspan (2003) at the Jackson Hole Symposium argued that what changed with the Great Moderation was the flexibility of the economy, with better inventory management, gradual deregulation, and greater flexibility of labor and financial markets. Despite the lack of agreement on the causes of the Great Moderation, the natural beginning point for explaining the recent increase in volatility is to judge if the forces that may have caused the Great Moderation could have reversed course.
Conclusion
The harshness of the depression that started in late 2007 has caused some observers to make conclusions. They claim that the Great Moderation which began in the U.S. in the mid-1980s over. The recession was the most horrible in the post-war period, generating an unprecedented decrease in economic activity.
This article examines if the Great Moderation is over. Some argue that that the global financial crisis has just gone through a bad recession. It is therefore natural to see increase aggregate volatility during the financial crisis and to anticipate higher volatility afterwards. After such a period we can expect to have back levels alike to the 1984-2007 periods. With time, macroeconomic volatility will probably experience irregular shifts between high and low levels with low volatility being the norm. In this sense, the Great Moderation is not dead.
References
Abel, A. B., & Bernanke, B. (2005). Macroeconomics. Reading, Mass: Addison-Wesley.
Giannone, D., Lenza, M., & Reichlin, L. (2008). Explaining the great moderation. Frankfurt, M: Europ. Central Bank.
Perri, F., Fogli, A., & National Bureau of Economic Research. (2006). The "Great Moderation" and the U.S. external imbalance. Cambridge, Mass: National Bureau of Economic Research.
