Can Financial Innovation Help To Explain The Reduced Volatility Of Economic Activity PDF Download

Congress is concerned with the health of the U.S. economy, which affects the living standards of all Americans. The 2001 recession was unusually mild and brief by historical standards. At 120 months, the expansion that preceded it had been the longest in U.S. history. Is this a coincidence? A body of research concludes that it is not. Since 1984, the volatility of economic growth has fallen by more than half. Before 1984, the fluctuations in quarterly growth rates were much more extreme from one quarter to the next. After 1984, the changes from quarter to quarter have become much smoother. Economists have coined this phenomenon the "great moderation." There are three competing theories for what has caused it. One theory is that structural changes within the economy have made it less volatile. Changes in the structure of the economy include a smaller manufacturing sector, better inventory management, financial innovations, and deregulation. Most economists have concluded that the shift in production across different sectors since 1984 has not been large enough to account for most of the great moderation. A second theory is that improved policy is the cause of the great moderation. In particular, some economists blame the deep and long recessions of the 1970s and 1980s on bad monetary policy; they credit improved monetary policy for the subsequent improvement in economic performance. They point to the simultaneous decline in the volatility of price inflation as evidence supporting their theory. But better policy is usually credited with creating longer economic expansions and shallower recessions. A smoother business cycle is only part of the great moderation; it can also be seen in terms of lower volatility from one quarter to the next. The third theory is that the great moderation is simply a case of better luck, while the 1970s and early 1980s were filled with bad luck, in the form of a series of economic shocks that barraged the economy. For example, oil shocks and the productivity slowdown coincided with the recessions of the 1970s and 1980s. The "better luck" theory has trouble explaining why the most recent oil shock and other recent economic disruptions did not cause a recession, however. All three explanations have likely played a role in the great moderation, but there is no consensus as to which has been most important. It is difficult to prove conclusively which of the three theories can best explain the great moderation, because the theories have been tested with different economic models that generate results that cannot be directly compared. Since no model has proven to be a reliable predictor of economic activity, it is not clear which model to favor. Even when similar models are used, the results have been open to different interpretations. In essence, much of the great moderation cannot be explained with existing economic tools, which could either be evidence supporting the better luck theory or signify that the real cause has not yet been identified. This report will not be updated.