What Caused the Decline in US Business Cycle Volatility?

This paper investigates the sources of the widely noticed reduction in the volatility of American business cycles since the mid 1980s. Our analysis of reduced volatility emphasises the sharp decline in the standard deviation of changes in real GDP, of the output gap, and of the infl ation rate. The primary results of the paper are based on a small three-equation macro model that includes equations for the infl ation rate, the nominal federal funds rate, and the change in the output gap. The development and analysis of the model goes beyond the previous literature in two directions. First, instead of quantifying the role of shocks in general, it decomposes the effect of shocks between a specifi c set of supply-shock variables in the model’s infl ation equation, and the error term in the output gap equation that is interpreted as representing ‘IS’ shifts or ‘demand shocks’. It concludes that the reduced variance of shocks was the dominant source of reduced business cycle volatility. Supply shocks accounted for 80 per cent of the volatility of infl ation before 1984 and demand shocks the remainder. In contrast, roughly two-thirds of the high level of output volatility before 1984 is accounted for by the output errors (demand shocks) and the remainder by supply shocks. The output errors are tied to the paper’s initial decomposition of the demand side of the economy, which concludes that three sectors – residential and inventory investment and federal government spending – account for 50 per cent of the reduction in the average standard deviation of real GDP when the 1950–83 and 1984–2004 intervals are compared. The second innovation in this paper is to reinterpret the role of changes in Fed monetary policy. Previous research on Taylor rule reaction functions identifi es a shift in the Volcker era toward infl ation fi ghting with no concern about output, and then a shift in the Greenspan era to a combination of infl ation fi ghting and strong countercyclical responses to output gaps. Our results accept this characterisation of the Volcker era but fi nd that previous estimates of Greenspan era reaction functions are plagued by positive serial correlation. Once a correction for serial correlation is applied, the Greenspan era reaction function looks almost identical to the pre-1979 Burns reaction function! Thus the issue in assessing monetary policy regimes comes down to Volcker versus non-Volcker. Full-model simulations show that the Volcker reaction function, 1. I am grateful to Ian Dew-Becker and Chris Taylor for inspired research assistance, extended through many evenings and several weekends, and to Dan Sichel, Kevin Stiroh, and Mark Watson for discussions and references. 5 Gordon.indd 64 23/9/05 12:03:56 PM 65 What Caused the Decline in US Business Cycle Volatility? if applied throughout the 1965–2004 period, would have delivered substantially higher pre-1984 output volatility than the Burns-Greenspan alternative, with the corresponding benefi t of a permanent reduction in the infl ation rate of 5 percentage points per annum. Compared to the succession of three reaction functions actually in effect, application of the Volcker reaction function prior to 1979 would have deepened the 1975 recession, but made the 1981–82 recession milder, since by then infl ation would have been partly conquered. The paper concludes by disputing the view that better monetary policies had any role in the reduced volatility of the business cycle – the Greenspan policies did not need to fi ght against infl ation because there was no infl ation, thanks to the reversal from adverse to benefi cial supply shocks, and thanks to a reduction in the size of the output errors, or ‘IS’ shifts.