Smoothing the Shocks of a Dynamic Stochastic General Equilibrium Model

E C O N O M I C R E V I E W Second Quarter 2005 The 2001 recession displayed unique characteristics in comparison to other recessions. Although moderate in terms of the decline in output, the recession was unique in that the contraction in measured output was driven almost entirely by retrenchment in business capital spending. Consumer spending growth remained positive, and residential investment maintained a very high level. Real gross domestic product (GDP) declined just 0.2 percent from its peak in the fourth quarter of 2000 to its trough in the third quarter of 2001. During this period, business investment in equipment and software fell 8.0 percent while consumer spending and residential investment grew 1.1 and 2.4 percent, respectively. Certain aspects of the recession, however, were fairly typical. The drop in payroll employment over the course of the recession was comparable to that in previous recessions—1.67 million, or 1.3 percent of total employment. In addition, as in every post–World War II recession, inflation rose just prior to the onset of the recession. Just as the recession itself was in some ways unique, so too was the recovery that followed. Most recessions are followed by strong recoveries with above-trend real GDP growth and a turnaround in the labor market. The recovery following the 2001 recession, however, was characterized by moderate, uneven growth in output and employment losses that continued well after the end of the recession. Real GDP growth was just 2.3 percent in 2002, and employment declines continued into May 2003, totaling another 1 million jobs. On the other hand, core inflation, low by historical standards as the downturn began, moderated during this recovery period, consistent with previous episodes. The characteristics of the 2001 recession and subsequent recovery have raised many questions about the conventional wisdom for post–World War II U.S. business cycles. If we believe that recessions are caused by external shocks to the economy, what type of perturbations or shocks affected U.S. output and inflation during the 2001 recession? Did these shocks persist after the end of the recession and into the recovery Smoothing the Shocks of a Dynamic Stochastic General Equilibrium Model