What is The Great Moderation
The Great Moderation is the name given to the period of decreased macroeconomic volatility experienced in the United States since the 1980s. During this period, the standard deviation of quarterly real GDP declined by half, and the standard deviation of inflation declined by two-thirds, according to figures reported by U.S. Federal Reserve Chairman Ben Bernanke. Increased economic volatility in the late 2000s has led many to question whether this period of economic stability was merely transitory.
BREAKING DOWN The Great Moderation
The structural changes Bernanke referred to included the widespread use of computers to enable more accurate business decision making, advances in the financial system, deregulation, the economy's shift toward services and increased openness to trade. Bernanke also pointed to improved macroeconomic policies which helped to moderate the large boom and bust cycles of the past. Indeed, many economists point to a gradual stabilizing of the U.S. economy correlated with increasingly sophisticated theories of monetary and fiscal policy. Finally, Bernanke refers to studies indicating that greater stability has resulted from a decrease in economic shocks during this period, rather than a permanent improvement in stabilizing forces.
Possible Causes of The Great Moderation
Economists have theorized three possible reasons for the advent of The Great Moderation: changes in the structure of the economy, good policy and good luck.
Structural changes in an economy can reduce volatility. For example, since manufacturing tends to be volatile, the shift from manufacturing to services can reduce volatility. The adoption of “just-in-time” inventory practices could have also been a factor, as it reduces the volatility of the inventory cycle. Similarly, advances in information technology and communications may have allowed firms to produce more efficiently and monitor their production processes more effectively, thereby reducing volatility in production—and thus in real GDP. Deregulation of many industries may have increased the flexibility of the economy and enabled the economy to adjust more smoothly to various types of shocks. More open international trade and capital flows may have also helped stabilize the economy.
Good monetary policy, is another possible reason for The Great Moderation. Monetary policy is generally thought to have performed better during The Great Moderation than in earlier periods. After inflation climbed from below 2 percent in the mid-1960s to over 12 percent in the mid-1970s, Federal Reserve Chairman Paul Volcker brought it down and returned the focus of monetary policy to price stability, thereby laying the foundation for the Great Moderation.
The United States may have also just been lucky that shocks hitting the economy during the Great Moderation were simply smaller than the large, adverse shocks of the 1960s and 1970s.