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What Caused the Decline in U. S. Business Cycle Volatility? Robert J. Gordon Northwestern University Presented at Reserve Bank of Australia, July 11, 2005 Instant Obsolescence in Macroeconomics Prosperity in 1960s bred conferences on “Is the Business Cycle Obsolete?” My 1984 conference came after the two large recessions of 1974-75 and 1981-82 But on the day of the conference, the business cycle changed again, continuing the tradition of “instant obsolescence” No disputing the decline in volatility since 1984, but why? Numerous participants in last week’s Fed conference took it for granted that it was an achievement of monetary policy Earlier Explanations of Postwar Stability Compared to pre-1929 Increased share of government, higher tax base creates automatic stabilizers Less procyclicality of money supply FDIC, Other Financial Market Reforms Stabilization within Postwar, before and after 1984 Shocks Demand shocks Federal government now the culprit not the saviourFinancial and banking reforms Inventory management Financial Market Deregulation stabilized residential housing Supply shocks, a main focus of this paper Improved monetary policy Of Lesser Importance Shifts in shares to services Preview of Paper Composition analysis across 11 components of spending on GDP Role of composition shifts vs. reduction in withinsector volatility Isolation of three sectors as most responsible for improved stability; support for demand shocks Building a three-equation macro model Inflation, Taylor Rule, Change in Output Gap In the spirit of Stock-Watson two papers, but a more explicit interpretation of the shocks and a surprising result about monetary policy Initial Evidence on Reduced Volatility (4-qtr Δ Real GDP) 14 12 Actual Real GDP Growth 10 Percent per year 8 6 4 2 0 -2 Average Real GDP Growth -4 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Rolling 20-quarter Standard Deviation of 4-qtr Δs in Real GDP, 2.8 vs. 1.3 pre/post 1988:Q1 4.5 4 3.5 Percent 3 2.5 2 1.5 1 0.5 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 What About Changes in Natural Output Growth? A Better Criterion: the Output Gap 10 8 6 Log Output Ratio 4 2 0 -2 -4 -6 -8 -10 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Stability Less Obvious but Still Significant, Decline 42% vs. 57% 4.5 4 3.5 Percent 3 2.5 2 1.5 1 0.5 0 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Inflation vs. Output Volatility: Sometimes the Same, but Other Times Different 4.5 4 Real GDP Growth Volatility 3.5 3 2.5 2 1.5 1 0.5 Inflation Volatility 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Turn to Tables for Decomposition Analysis Table 1: Standard Deviations and Shares of 11 Sectors Table 2: Effect of Shifts in Shares and Own-Sector Volatility Table 3: Contributions to GDP Change: Emphasis on Residential Investment, Inventory Investment, and Federal Spending Building the Three Equation Model Combines my “mainstream” or “triangle” approach to explaining inflation Inertia Demand through output or U gap Specific supply shocks “Taylor Rule” equation for Fed Funds rate Coefficients allowed to change, 1979 and 1990 Output gap equation with feedback from interest rate changes The Inflation Equation: the Distinguishing Features Long 24-quarter lags on past inflation No pretense that these represent expectations – some unknown combination of expectations, wage contracts, price contracts Demand enters through the unemployment gap Time-varying NAIRU estimated as part of equation estimation “No-shock” concept of NAIRU Supply-shock variables Changes in the relative price of imports The food-energy effect The medical care effect Acceleration and deceleration of the productivity growth trend Nixon-era controls, held down inflation in 1971-72, boosted inflation in 1974 Changes in Relative Import Prices 15 10 5 0 -5 -10 -15 1960 1965 1970 1975 1980 1985 1990 1995 2000 The Food-Energy Effect 4 3 2 1 0 -1 -2 1960 1965 1970 1975 1980 1985 1990 1995 2000 The Medical Care Effect 0.6 0.5 0.4 Percent 0.3 0.2 0.1 0 -0.1 -0.2 1960 1965 1970 1975 1980 1985 1990 1995 2000 The Productivity Growth Trend Acceleration 0.8 0.6 Percent 0.4 0.2 0 -0.2 -0.4 -0.6 1960 1965 1970 1975 1980 1985 1990 1995 2000 Actual Unemployment Rate and the Time-Varying NAIRU (TVN) 12 10 8 Time Varying NAIRU 6 4 Actual Unemployment Rate 2 0 1962:01 1967:01 1972:01 1977:01 1982:01 1987:01 1992:01 1997:01 2002:01 Coefficients of Inflation Equation are in Table 4 Brief Comments on Size and Sign of Coefficients Importance of Testing Inflation Coefficients with Dynamic Simulations Results in Bottom of Table 4: Estimate coefficients through 1994:Q4, simulation 1995:Q1 to 2004:Q4 (40 quarters) Qualification: The Simulation Knows the Time-Varying NAIRU A Longer Simulation: 160 Quarters Knowing the TVN and the full-period coefficients 12 10 Predicted Inflation w ith Actual Shocks, 1965-2004 8 6 4 2 0 1960 Actual Inflation 1965 1970 1975 1980 1985 1990 1995 2000 The Dramatic Effect of Supply Shocks 12 10 8 Predicted Inflation w ith Actual Shocks, 1965-2004 6 4 2 Predicted Inflation w ith Shocks Suppressed, 1965-2004 0 -2 -4 -6 1960 1965 1970 1975 1980 1985 1990 1995 2000 The Interest Rate Equation R = T* + p* + a(p-p*) + b(Ygap) Estimated over three time intervals 1960-79 1979-90 1990-2004 Coefficients presented in Table 5 After 1979, Fed fought inflation After 1990, Fed fought both infl & Ygap Actual and Predicted Values of Fed Funds Rate 20 18 16 14 Actual 12 10 Predicted 8 6 4 2 0 1965:01 1970:01 1975:01 1980:01 1985:01 1990:01 1995:01 2000:01 Interest Rate Error: Sustained after 1994 4 3 Estimated Error Term 2 1 0 -1 -2 -3 -4 -5 1965:01 1970:01 1975:01 1980:01 1985:01 1990:01 1995:01 2000:01 The Output Gap Equation First Difference of Output Gap regressed on First Difference of Inflation Rate First Difference of Lagged Nominal Fed Funds Rate, quarters 2-10 (why?) Real vs. Nominal Rates? An Central Concept in the Paper: “The Output Error” Predicted Output Values Miss, Especially after 1990 8 6 Est imat ed Error Act ual 4 2 0 -2 -4 Predict ed -6 -8 -10 1965:01 1970:01 1975:01 1980:01 1985:01 1990:01 1995:01 2000:01 Full Model Simulations: Table 7 Here is Inflation 14 12 10 8 All Shocks 6 No Interest Error No Supply Shocks 4 2 No Shocks No Output Error 0 -2 1965:01 1970:01 1975:01 1980:01 1985:01 1990:01 1995:01 2000:01 Full-Model Simulation of the Federal Funds Rate (Split Sample) 25 20 15 All Shocks 10 No Supply Shocks No Int erest Error 5 No Shocks 0 1965:01 1970:01 1975:01 No Out put Error 1980:01 1985:01 1990:01 1995:01 2000:01 The Basic Conclusion of the Paper: The Output Gap Simulations 8 6 All Shocks 4 No Out put Error No Shocks 2 0 -2 No Int erest Error -4 No Supply Shocks -6 -8 -10 -12 1965:01 1970:01 1975:01 1980:01 1985:01 1990:01 1995:01 2000:01 Bottom of Table 7: Summary of Output Gap Conclusions Standard Deviation of Output Gap Absolute Value of Output Gap Supply Shocks and the Output Error were Roughly equal culprits No Role of Interest-rate Error Effects of Changes in Monetary Policy Feedback Responses 6 4 2 0 90:3-04:4 -2 60:1-79:2 -4 -6 Split Sample 79:3-90:2 -8 -10 1965:01 1970:01 1975:01 1980:01 1985:01 1990:01 1995:01 2000:01 Conclusions Demand and Supply Shocks both Mattered The Major Demand Shocks were Military Spending, Financial Institutions that Destabilized Residential Investment, and Primitive Inventory Management The Major Supply Shocks were Import Prices (and Flexible Exchange Rates), Food-Oil Prices, Medical Care Prices, Productivity Trend, and Nixon Controls Role of Monetary Policy Accommodative Policy in the 1970s Allowed Inflation to Take off Made 1981-82 Recession Worse Volcker Post-1979 Monetary Policy Created Instability Best Policy of All: Greenspan Policy applied to entire postwar period! Combined inflation and output target beats a pure inflation target by every criterion