Transcript What Caused the Decline in U. S. Business Cycle Volatility?

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