Great Moderation: A Multi-Country Analysis

The study utilizes time-varying parameter vector autoregressions (TVP-VAR) to analyze volatility changes in output growth and inflation across eight countries with at least 140 years of uninterrupted annual data. This approach allows for the coefficients of the model to change over time, accommodating potential stochastic volatility in the errors. The selection of eight countries—the United States, the United Kingdom, Sweden, Italy, Finland, Denmark, Canada, and Australia—was dictated by the availability of long, uninterrupted annual time series. The researchers acknowledge the limitations imposed by data availability, noting that many other countries lack similarly reliable and extensive data. Data sources for output growth and inflation rates varied across countries, sometimes involving splicing data from different sources. Despite these variations, the major results proved robust across most countries. The study's advantage lies in its ability to examine long-term economic changes under vastly different conditions, including the 19th century, the Great Depression, World War I, World War II, and the post-war era, allowing for an in-depth understanding of economic volatility in various periods. The long time series allows a detailed study of macroeconomic aggregates. This also makes it possible to address the question of whether the observed volatility is associated with shifts in policy or non-policy related events. The paper directly addresses concerns about data quality by comparing results across different datasets and historical periods, enhancing the robustness of the findings.

A central focus is comparing the Postwar Moderation (following World War II) and the Great Moderation (late 1970s onwards). The study finds that the decline in volatility during the Postwar Moderation consistently exceeded that of the Great Moderation across all eight countries, often by a substantial margin. For example, the United States experienced almost a 60% drop in output growth volatility during the Postwar Moderation, compared to a 36% decrease during the Great Moderation. This finding challenges the commonly held belief that the Great Moderation represents an unprecedented event. The analysis also shows that in most countries, the recent financial crisis has not only negated the stability gains of the Great Moderation but also eroded some of the gains achieved during the Postwar Moderation, indicating a return to higher volatility levels. While the Classical Gold Standard period (1880-1914) also exhibited relatively low volatility for both output growth and inflation in some countries, the Postwar Moderation represented a more substantial and sustained reduction in volatility, especially when excluding the Classical Gold Standard period. Specific examples such as the Scandinavian financial crisis of the early 1990s in Sweden and Finland, illustrate instances where this pattern of reduced volatility was interrupted by regional economic events. The study highlights that output growth volatility almost always reached its lowest point after the Great Moderation, indicating a significant influence of the more recent period on overall stability. The analysis meticulously examines the differences in the magnitude of volatility changes during these two periods of economic stability.

The research investigates the influence of structural shocks on volatility using the Blanchard and Quah (1989) decomposition, which separates output shocks into permanent (aggregate supply) and transitory (aggregate demand) components. Although acknowledging the limitations of this approach, the study finds that aggregate supply shocks predominantly drive changes in output growth volatility, while aggregate demand shocks are the primary contributors to inflation volatility fluctuations. This finding offers insights into the underlying drivers of macroeconomic volatility. The paper further notes a correlation between periods of widespread fixed exchange rate systems (like the Classical Gold Standard and the Bretton Woods system) and relatively low volatilities, suggesting a potential stabilizing effect of such regimes. However, it also points out that low volatility isn't solely dependent on fixed exchange rate systems, as low volatilities were also observed in the recent period without a global fixed exchange rate regime. The timing of the Postwar Moderation coincides with the Bretton Woods system, providing support to this observation. The analysis also examines the increase in volatilities during the 1970s, potentially attributed to higher variance in oil supply shocks or the failure of central banks to adhere to the Taylor Principle, leading to indeterminacy in equilibrium. The impact of policy changes, such as the Employment Act of 1946 in the United States, is considered as a potential contributor to the Postwar Moderation. The study offers a comprehensive examination of the interplay between structural shocks and macroeconomic policies influencing the observed volatility patterns. It acknowledges and addresses limitations related to using the Blanchard and Quah approach while extracting useful empirical regularities.

The core comparison centers on the magnitude of volatility reductions during the Postwar Moderation (post-World War II) and the Great Moderation (late 1970s onwards). The study reveals a consistently larger decline in both output growth and inflation volatility during the Postwar Moderation across all eight countries examined (United States, United Kingdom, Sweden, Italy, Finland, Denmark, Canada, and Australia). The difference in reduction magnitude is often substantial. For instance, the US experienced a nearly 60% decrease in output growth volatility during the Postwar Moderation, compared to only 36% during the Great Moderation. This finding directly contradicts the commonly held perception that the Great Moderation represents an unprecedented event. The analysis meticulously quantifies the percentage changes in standard deviation for both output growth and inflation during both periods, highlighting the significantly greater impact of the Postwar Moderation. This comparison forms the crux of the paper's argument, challenging established interpretations of macroeconomic stability. The detailed analysis of volatility changes across different countries and time periods highlights the significant and consistent difference in the magnitude of the volatility reductions during the two periods.

The study assesses the lasting impact of the recent financial crisis on the stability gains achieved during both the Postwar and Great Moderations. The key observation is that in almost all countries, volatility levels have risen above the lows observed during the Postwar Moderation. This signifies that the Great Moderation's stability gains have been completely eroded, and in several instances, the gains of the Postwar Moderation have also been partially lost. This finding implies that many economies face a protracted period of recovery to reach the low volatility levels previously observed. The analysis doesn't dismiss policymakers' ability to restore stability, but it emphasizes the significant challenge represented by the current levels of macroeconomic volatility. By comparing current volatility with historical lows during both periods of moderation, the study underscores the significant setback caused by the recent crisis and the long road to recovery for many economies. The analysis of the impact of the recent financial crisis sets the stage for further discussions on policy responses and macroeconomic stability.

The analysis acknowledges that the Postwar Moderation isn't a simple return to pre-World War II levels of volatility. Rather, it marks the start of a period with persistently lower volatility. In many cases, the gains of the Great Moderation largely reverse the rise in volatility that occurred in the 1970s, especially for inflation. The study also notes that volatilities were relatively low during the Classical Gold Standard period (1880–1914). However, excluding this period, volatilities remain lower after the Postwar Moderation than at any other point before World War II. This broader perspective on volatility patterns helps contextualize the significance of both the Great and Postwar Moderations. The Scandinavian financial crisis in the early 1990s serves as an example of a period of increased volatility, primarily affecting Sweden and Finland, contrasting with the broader trend of moderation in other countries during the late 1980s and early 1990s. This illustrates how localized economic crises can interrupt longer-term trends in macroeconomic stability. The analysis of various exceptional periods provides a more comprehensive view of the dynamics of macroeconomic volatility. The findings are further reinforced by the robustness of the results across multiple datasets and countries, showing the consistency of the conclusions despite variations in data quality and sources.

The study employs the Blanchard and Quah (1989) decomposition to analyze the impact of structural shocks on volatility. This method separates output shocks into permanent (aggregate supply) and transitory (aggregate demand) components. While acknowledging potential limitations of this approach, particularly the potential for aggregate demand shocks to have permanent effects on output, the study finds that aggregate supply shocks are the primary drivers of output growth volatility. Conversely, aggregate demand shocks primarily account for fluctuations in inflation volatility. This finding, though subject to the acknowledged limitations of the BQ decomposition, provides valuable insights into the source of volatility in these key macroeconomic variables. The authors discuss potential issues with the Blanchard and Quah approach, acknowledging that each identified shock represents an aggregate of multiple underlying shocks and that the identification scheme's validity hinges on macroeconomic variables responding to particular structural shocks in qualitatively consistent ways. Despite these caveats, the decomposition offers a useful statistical model for uncovering empirical regularities and informing the evaluation of different economic theories concerning the influence of these structural factors on volatility.

The research investigates the relationship between exchange rate regimes and macroeconomic volatility. The analysis shows a strong association between periods of widespread fixed exchange rate systems and lower volatility levels for both output growth and inflation. Examples cited include the Classical Gold Standard period (1880-1914) and the Bretton Woods system. The study's findings suggest that fixed exchange rate systems may contribute to macroeconomic stability, although it acknowledges that this is not a necessary condition for low volatilities. The timing of the most dramatic declines in post-war output growth and inflation volatilities, which coincide with the Bretton Woods exchange rate regime, points to a possible link between fixed exchange rates and reduced economic volatility. However, the study clarifies that even during the Great Moderation period, exchange rates were not fully flexible for some countries, implying a more nuanced relationship between exchange rate regimes and volatility. The Classical Gold Standard serves as a natural experiment for assessing the effect of a fixed exchange rate system on economic fluctuations. The study notes that the recent period of low volatilities occurred without a global fixed exchange rate system, indicating that low volatility can be achieved under other conditions. The analysis explores the influence of different exchange rate regimes on macroeconomic stability. This analysis contributes to a broader discussion of the role of macroeconomic policy and exchange rate systems in maintaining economic stability and reducing output growth and inflation volatility.

The study discusses policy implications related to the observed volatility patterns. The timing of the significant decline in volatilities following World War II, particularly in the United States, is linked to the government's emphasis on economic stabilization and the Employment Act of 1946. The sharp increase in volatility during the 1970s is examined, with potential explanations including the increased variance of oil supply shocks and the possible failure of central banks to adhere to the Taylor Principle. The failure to follow the Taylor principle may have led to an indeterminate equilibrium, contributing to higher volatility. The research highlights the interplay between policy choices and macroeconomic outcomes in shaping the volatility of output growth and inflation. The study emphasizes that a deeper understanding of the fundamental causes of large movements in volatility is crucial for crafting more effective welfare-improving economic policies. By examining specific policy decisions and their effects, the study highlights the importance of policy responses in shaping macroeconomic stability and the volatility of output growth and inflation. The authors suggest further research on understanding how different economic theories explain the observed volatility patterns across various periods.

Despite variations in data sources and methodologies across countries, the study reveals remarkably consistent patterns in the volatility of output growth and inflation across the eight nations studied. These patterns include a sharp increase in volatility coinciding with and following World War I, relatively high volatility until the end of World War II, and a subsequent rapid decline until the mid-to-late 1960s. This consistent pattern across diverse economies suggests underlying common factors, strengthening the overall conclusions. The study explicitly addresses the issue of data quality variations, noting differences in data sources (GNP or GDP; chain-weighted or fixed base year measures) and splice dates. Despite these discrepancies, the major results remain robust across almost all eight countries, lending significant credibility to the study’s findings. The authors note that while the availability of long, uninterrupted annual time series limited their sample to eight countries, the consistent patterns observed strengthen the argument and are not likely due to issues with data quality. The consistency of the results highlights the robustness of the findings, suggesting that the observed patterns in volatility are not merely artifacts of data limitations but rather reflect underlying economic realities.

While consistent patterns emerged, the study also identifies country-specific deviations from the general trends. For instance, the Scandinavian financial crisis in the early 1990s significantly impacted Sweden and Finland, causing increases in volatility during a period when other countries experienced moderation. Similarly, Denmark's relatively modest Great Moderation is attributed to spillover effects from the crisis impacting its neighbors. These exceptions demonstrate the importance of considering country-specific factors in addition to broader economic trends. The study notes that output growth volatility in most countries peaked around World War I, while the lowest levels were reached following the Great Moderation (except for Sweden). Inflation volatility, excluding Canada, typically reached its lowest point in the 1990s or 2000s. These observations underscore the necessity of analyzing country-specific factors to provide a complete picture of macroeconomic volatility. The paper provides explanations for these deviations. For example, the sharp rise in inflation volatility in several countries in the 1970s is analyzed in light of the increase in oil prices and the potential malfunction of monetary policy, where central banks might not have followed the Taylor Principle. This tailored analysis of country-specific responses strengthens the robustness of the study’s findings. The study's attention to these exceptions highlights the complexity of macroeconomic volatility and emphasizes the need for nuanced analyses that consider both broader trends and country-specific economic factors.

The paper directly addresses concerns regarding the quality of historical data, particularly for the pre-1930 period. It leverages alternative US datasets from Romer (1989) and Balke and Gordon (1989) to assess the robustness of findings. These comparisons demonstrate the consistency of results across different data sources. Furthermore, the authors address concerns about data quality differences between the US and other countries. They compare the US results using lower-quality historical data (Mitchell 2003b) spliced to higher-quality modern data with the results using only high-quality US data, demonstrating that the results are largely consistent. They also point to the generally better source material for European countries compared to the US, potentially mitigating data quality concerns for the European countries. The authors emphasize that the consistent findings across countries and across different data samples strongly support the robustness of their conclusions and diminish the likelihood that results are significantly influenced by data noise or methodological limitations. The various robustness checks undertaken enhance the credibility and reliability of the study's findings regarding the dynamics of macroeconomic volatility.

The study concludes that many patterns of change in output growth and inflation volatilities are remarkably consistent across the eight countries analyzed. These include sharp increases linked to World War I, sustained high volatility until after World War II, and then rapid declines until the mid-to-late 1960s. This robust consistency across diverse economies strengthens the credibility of the findings, suggesting underlying structural factors influencing volatility rather than country-specific idiosyncrasies. The research highlights the significant tendency for volatilities to be lower after the Postwar Moderation, frequently surpassing the reductions observed during the Great Moderation. The robustness of these findings is further emphasized by the authors' discussion of data quality considerations and the application of various robustness checks which consistently yielded similar results across different data sources and methodological approaches. This consistency across various datasets and methodologies underpins the study’s conclusion, supporting the view that the observed volatility patterns reflect fundamental economic phenomena rather than methodological artifacts or data noise.

The study emphasizes the importance of understanding the fundamental causes of major movements in macroeconomic volatility to guide the development of effective policies. The findings point to a strong association between policy changes (such as widespread fixed exchange rate systems and a greater post-World War II emphasis on economic stabilization) and volatility levels. Conversely, the rise in volatilities during the 1970s suggests potential failures in monetary policy adherence to the Taylor Principle. This highlights the need for policymakers to consider the impact of their decisions on macroeconomic stability and the long-term effects on the volatility of output growth and inflation. The substantial difference in the magnitude of volatility reductions between the Postwar Moderation and the Great Moderation underscores the complexity of macroeconomic stability and the need for further research. The authors suggest the use of Dynamic Stochastic General Equilibrium (DSGE) models to evaluate the factors influencing volatility and aid in distinguishing between competing economic theories. The study concludes by calling for improved understanding of the underlying drivers of volatility to foster the development of policies designed to improve economic welfare.

The conclusion summarizes key findings, emphasizing the consistent observation of greater volatility reductions during the Postwar Moderation compared to the Great Moderation across all eight countries. It reiterates that the recent financial crisis has reversed much of the gains from the Great Moderation, and, in some cases, even gains from the Postwar Moderation. The study highlights the role of both policy changes and major macroeconomic shocks in driving volatility fluctuations. The Classical Gold Standard is identified as a period with unusually low volatility in many countries, offering a historical benchmark for comparative analysis. The analysis of the contributions of aggregate supply and aggregate demand shocks to the volatility of output growth and inflation, using the Blanchard-Quah decomposition, helps refine the understanding of the underlying economic drivers. The paper concludes by reiterating the need to better understand the fundamental causes of large movements in output growth and inflation volatility to effectively improve policies and economic outcomes. The authors point out avenues for future research, including using DSGE models to examine the influence of various factors on economic volatility.