In economics, the Great Moderation refers to a reduction in the volatility of business cycle fluctuations starting in the mid-1980s, believed to have been caused by institutional and structural changes in developed nations in the later part of the twentieth century. Sometime during the mid-1980s major economic variables such as real gross domestic product growth, industrial production, monthly payroll employment and the unemployment rate began to decline in volatility.
Origins of the term
Chang-Jin Kim and Charles Nelson (1999) and Margaret McConnell and Gabriel Pérez-Quirós (2000) calculated that U.S. output volatility had declined substantially in the early 1980s. This phenomenon was called a "great moderation" by James Stock and Mark Watson in their 2002 paper, "Has the Business Cycle Changed and Why?". It was brought to the attention of the wider public by Ben Bernanke (then member and now chairman of the Board of Governors of the Federal Reserve) in a speech at the 2004 meetings of the Eastern Economic Association.
The Great Moderation has been attributed to various causes:
- Improved government economic stabilization policy (particularly monetary policy)
- Greater central bank independence, in which the US Federal Reserve balanced money supply more closely with demand
- Reduced, or stabilized, government regulation and taxation
- Improved inventory control and supply chain management
- Economic good luck (partly from productivity and commodity price shocks)
Researchers at the US Federal Reserve and at the European Central Bank have rejected the "good luck" explanation and attribute it mainly to improved monetary policies. According to John B. Taylor, originator of the Taylor rule, the Great Moderation resulted from the abandonment of discretionary macroeconomic policy by the US Federal government, and the adoption of a rules-based macroeconomic policy instead (working mainly through monetary policy). Research has indicated that US monetary policy contributed to the drop in the volatility of US output fluctuations and to the decoupling of household investment from the business cycle that characterized the Great Moderation.
It has been argued that the greater predictability in economic and financial performance associated with the Great Moderation caused firms to hold less capital and to be less concerned about liquidity positions. This, in turn, is thought to have been a factor in encouraging increased debt levels and a reduction in risk premia required by investors.. According to Hyman Minsky the great moderation enabled a classic period of financial instability, with stable growth encouraging greater financial risk taking.
On the economics profession
An example of the over confidence of the economic profession in this period (prior to 2008) given by Robert Lucas, in his 2003 presidential address to the American Economic Association, where he declared that the "central problem of depression-prevention [has] been solved, for all practical purposes".
Economists speculate that the late-2000s economic and financial crisis may have brought the period of the Great Moderation to an end. Richard Clarida at PIMCO considers the period of the Great Moderation to be roughly between 1987 and 2007, and it is characterised by "predictable policy, low inflation, and modest business cycles".
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- What Have We Learned Since October 1979? Remarks by Fed governor Ben Bernanke (2004)
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- Inflation targets and central bank independence
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- Federal Reserve Bank of Chicago, Monetary Policy, Output Composition and the Great Moderation, June 2007
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"Home page of Robert E. Lucas, Jr. at the University of Chicago".
- Quiggin, John (2011). "Refuted economic doctrines #3: The Great Moderation". Crooked Timber. Retrieved 15 April 2011.