Why Has the Economy Become Less Volatile?

Why Has the Economy Become Less Volatile?

Order Code RL33959
Has the Economy Become Less Volatile
Over Time?
Updated August 1, 2008
Marc Labonte
Specialist in Macroeconomic Policy
Government and Finance Division

Why Has the Economy Become Less Volatile?
Summary
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.
There are three competing explanations for what economists have called the
“great moderation.” One theory is that structural changes have made the economy
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.
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.
The recent slowdown would seem to point to an end to the great moderation.
But when one considers the significant shocks to the economy through housing, the
financial sector, and energy prices, the fact that growth in 2008 has nevertheless
remained positive can be seen as evidence that the “great moderation” continues.

Contents
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Three Possible Explanations for the Great Moderation . . . . . . . . . . . . . . . . . . . . . 4
Changes in the Structure of the Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Better Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Better Luck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
The 2008 Slowdown and the Great Moderation:
An Exception That Proves the Rule? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Policy Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
List of Figures
Figure 1. Quarterly GDP Growth, 1947-2008:2 . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Figure 2. Cumulative Change in GDP in Post-War Recessions
and Since 2007.4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
List of Tables
Table 1. Volatility of GDP and Its Components, 1959:3-2008:2 . . . . . . . . . . . . . 3

Why Has the Economy Become
Less Volatile?
Overview
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, beginning with
the studies of Kim and Nelson and McConnell and Perez-Quiros, concludes that it
is not.1 Economists have located 1984 as the break point when economic activity
changed; since that year, the volatility of economic growth (as measured by the
standard deviation) has fallen by more than half. Economic volatility can be seen in
Figure 1, which shows quarterly GDP growth from 1947 to 2006. 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 became much smoother.
This decline in economic volatility has been dubbed the “great moderation” by
economists.
Figure 1. Quarterly GDP Growth, 1947-2008:2
20
15
e
10
g
5
an
0
ch
%
-5
-10
-15
1947 1957 1967 1977 1987 1997 2007
Source: Bureau of Economic Analysis.
Note: The figure shows the percent change in real GDP from the previous quarter, annualized.
1 Chang-Jin Kim and Charles Nelson, “Has the U.S. Economy Become More Stable?,”
Review of Economics and Statistics, vol. 81, no. 4, November 1999, p. 608; Margaret
McConnell and Gabriel Perez-Quiros, “Output Fluctuations in the United States: What Has
Changed Since the Early 1980s,” American Economic Review, vol. 90, no. 5, December
2000, p. 1464.

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A common measure of volatility is the standard deviation, which measures how
much each observation in a sample differs from the sample’s average. When
economic growth becomes smoother, its standard deviation falls. Table 1 compares
the standard deviation of the growth rate of each category of GDP since 1984 to the
22 years preceding it. It illustrates that the decline in volatility has been broad based,
occurring across every major category of economic activity. The decline was
especially large in the categories of residential investment (despite the recent boom
and bust), exports, and imports.
Some categories of GDP are naturally more volatile than others; particularly
volatile categories include durable goods, all types of investment, exports, and
imports. The net effect of exports and imports on overall volatility is lower,
however, because GDP is affected by the difference between exports and imports,
and the two are somewhat positively correlated (i.e., they tend to rise and fall
together). All of these categories of GDP are volatile because they include many
discretionary purchases that are made less frequently — households can postpone
durable goods purchases and residential investment, and businesses can postpone
investment decisions until circumstances are favorable.
The least volatile categories of GDP include services, nondurable goods, private
inventories, and government expenditures. Services and nondurable goods tend to
be nondiscretionary purchases that households want to consume smoothly over time.
Federal government expenditures tend to be smooth because the government faces
less of a budget constraint than households and businesses, so it does not need to
reduce expenditures when revenues fall. For a sense of the degree of volatility
inherent in economic activity, consider that only for GDP, personal consumption,
nondurable goods, and services were the standard deviation lower than the average
growth rate out of all the categories in Table 1 since 1984.2
2 Since not all of the categories in Table 1 have similar average growth rates, direct
comparisons are a little tricky. If these differences are adjusted for by using a measure
called the coefficient of variation (calculated by dividing the standard deviation by the
average), the results are still broadly similar — different types of investment spending are
still the most volatile and different types of consumption are the least volatile. Exports and
imports show the biggest difference from Table 1 because their average growth rates are
high.

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Table 1. Volatility of GDP and Its Components, 1959:3-2008:2
(percentage change from previous quarter)
Correlation
Standard
Standard
w/GDP
Deviation
Deviation
growth
Gross Domestic Product
1984:1-2008:2
1959:3-1983:4
1984:1-2008:2
Personal consumption expenditures
1.9
3.4
0.5
Durable goods
10.8
15.0
0.3
Nondurable goods
2.1
3.2
0.5
Services
1.5
2.0
0.2
Gross private fixed domestic investment
6.9
10.9
0.6
Structures
11.5
11.6
0.3
Equipment and software
8.7
12.3
0.5
Residential
11.2 24.4
0.5
Private Inventories
2.7
3.0
0.5
Exports
7.8
23.4
0.4
Imports
8.1
20.0
0.4
Government expenditures
3.4
5.0
0.3
Overall Gross domestic product
2.1
4.4
N/A
Source: CRS calculations based on data from the Bureau of Economic Analysis.
Notes: Data are quarterly and annualized. Perfect correlation = 1, zero correlation = 0, perfect
negative correlation = -1. The change in private inventories, not private inventories (as used in this
chart), are a component of GDP.
Part of the volatility of overall GDP is random and part is due to the business
cycle. To determine which categories of GDP are most pro-cyclical, Table 1 also
presents the correlation between different categories of GDP and overall GDP. It
reveals that nondurable goods, equipment and software, private inventories, and
residential investment are the most pro-cyclical subcategories of GDP.
The great moderation is not a uniquely American experience. It has occurred
across all of the major advanced economies in the 1970s or 1980s, although the
timing and magnitude have differed somewhat from country to country.3
3 Peter Summers, “What Caused the Great Moderation? Some Cross Country Evidence,”
Federal Reserve Bank of Kansas City, Economic Review, vol. 90, no. 3, July 2005, p. 2;
Olivier Blanchard and John Simon, “The Long and Large Decline in U.S. Output
Volatility,” Brookings Papers on Economic Activity 1, 2001, p. 135; James Stock and Mark
Watson, “Has the Business Cycle Changed?”, in Monetary Policy and Uncertainty:
Adapting to a Changing Economy, Federal Reserve Bank of Kansas City, 2003, p. 19.

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Three Possible Explanations for
the Great Moderation
Economists have come up with three explanations for the great moderation:
changes in the structure of the economy, better policy, or better luck. While all three
explanations have likely played a role, economists have disagreed about which has
had the largest effect. These explanations are only as good as the models that
produce them; because economists do not have models that can predict economic
activity with a high degree of accuracy, it is not clear which results to favor. Each
possibility will be considered in turn below.
Changes in the Structure of the Economy
Part of the decline in volatility since 1984 stems from the fact that expansions
have been longer and recessions have been shallower. But Figure 1 shows that even
from one quarter to the next volatility has generally been lower. Thus, the story is
not just about the business cycle. The great moderation could be caused by structural
changes in the production process that are either unrelated to the business cycle or
help businesses better cope with the business cycle. Changes in the structure of the
economy include a smaller manufacturing sector, better inventory management,
financial innovations, and deregulation.
McConnell and Perez-Quiros single out a reduction in the volatility of durable
goods production, particularly because inventory accumulation became less volatile
within the sector, as the biggest difference between the pre-1984 and post-1984
periods.4 In a subsequent study, they and Kahn estimate that this factor could account
for two-thirds of the decline in volatility, and argue that the great moderation could
not have been caused by better policy or better luck since neither would be expected
to affect inventories.5 Blanchard and Simon see the shift in inventories from pro-
cyclical to counter-cyclical as an important reason that the business cycle has become
milder.6 Summers finds that a decline in inventory volatility and overall volatility
occurred across advanced economies.7 The well-documented shift to “real-time”
inventory management techniques could explain the decline in its volatility.
One of the largest structural changes in the past 50 years has been a shift in
economic activity toward less manufacturing and more services. But McConnell and
Perez-Quiros do not find statistical evidence that this shift caused the great
4 Margaret McConnell and Gabriel Perez-Quiros, “Output Fluctuations in the United States:
What Has Changed Since the Early 1980s,” American Economic Review, vol. 90, no. 5,
December 2000, p. 1464.
5 James Kahn, Margaret McConnell, and Gabriel Perez-Quiros, “On the Causes of the
Increased Stability of the U.S. Economy,” Federal Reserve Bank of New York, Economic
Policy Review, May 2002, p. 183.
6 Olivier Blanchard and John Simon, “The Long and Large Decline in U.S. Output
Volatility,” Brookings Papers on Economic Activity 1, 2001, p. 135.
7 Peter Summers, “What Caused the Great Moderation? Some Cross Country Evidence,”
Federal Reserve Bank of Kansas City, Economic Review, vol. 90, no. 3, July 2005, p. 2.

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moderation. Filardo agrees, and argues it is because the decline in manufacturing’s
share of employment was not matched by a significant decline in its share of real
output.8
There has also been a sharp decline in the volatility of residential investment,
as seen in Table 1. Stock and Watson argue that “Even though residential
investment is fairly small, because its variance is so large the reduction in volatility
(since 1984) ‘explains,’ in an accounting sense, a substantial fraction of the variance
reduction in GDP growth...”9 The decline in residential investment volatility may be
the result of policy changes, as discussed below.
To estimate how much of the great moderation is due to changes in the structure
of the economy, Stock and Watson re-weight the post-1984 economy to look like the
pre-1984 economy, and show that this explains less than 10% of the reduction in
volatility.10 They find mixed evidence that innovations in “real-time” inventory
management made an important contribution to the decrease in volatility. They
hypothesize that the decline in volatility of consumer spending and especially
residential investment may have been caused by financial innovations that increased
consumers’ access to credit, which allowed for smoother consumption patterns. But
this is contradicted by evidence at the micro level that consumption has become more
volatile in recent years.
Many other studies agree that structural causes cannot be the primary cause of
the great moderation, but a dissenting study by Eggers and Ioannides points out that
if one looks at the composition shift by industry rather than type of spending, the
composition effect is much larger.11
One weakness with the structural changes explanation is that the 1960s,
although more volatile than the post-1984 period, were much less volatile than the
1970s and 1980s. Any explanation based on changes in the structure of the economy
must explain what changes in the economy can explain why volatility increased in
the 1970s and then declined. Otherwise, either random luck or policy changes must
explain the pattern of changes in the economy’s volatility. Of course, an explanation
based on policy changes must be able to explain why there was a pattern of good
policy in the 1960s, bad policy in the 1970s and early 1980s, then returning to good
policy since.
8 Andrew Filardo, “Cyclical Implications of the Declining Manufacturing Employment
Share,” Federal Reserve Bank of Kansas City, Economic Review, vol. 82, no. 2, 1997:2, p.
63.
9 James Stock and Mark Watson, “Has the Business Cycle Changed?”, in Monetary Policy
and Uncertainty: Adapting to a Changing Economy, Federal Reserve Bank of Kansas City,
2003, p. 19.
10 Blanchard and Simon conduct a similar exercise with similar results. Olivier Blanchard
and John Simon, “The Long and Large Decline in U.S. Output Volatility,” Brookings
Papers on Economic Activity 1, 2001, p. 135.
11 Andrew Eggers and Yannis Ioannides, “The Role of Output Composition in the
Stabilization of U.S. Output Growth,” Journal of Macroeconomics, vol. 28, 2006.

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Better Policy
In the past fifty years, economic volatility was highest during the 1970s. This
was also the decade of the highest price inflation in the past fifty years, which many
economists have blamed on poor monetary policy decisions by the Federal Reserve.
Some economists believe that the improvement in policymaking subsequent to Paul
Volcker’s confirmation as Chairman of the Fed beginning in 1979 was also
(eventually) responsible for the great moderation.
In general, economists believe inflation rose in the 1970s because the Fed made
two mistakes. First, in this view, the Fed either did not understand that there was a
natural rate of unemployment, or they underestimated it (probably because, in
hindsight, the natural rate was rising at the time).12 Second, there was an unexpected
slowdown in productivity growth in the 1970s that was not quickly identified. The
productivity slowdown meant that the economy could no longer grow as rapidly as
the perceived target rate underlying Fed policy decisions. Both of these mistakes
meant that the Fed was trying to pursue unemployment and growth policies that
could not be sustained and caused inflation to rise. Economists consider monetary
policy to have failed in the 1970s not only because inflation was allowed to rise into
double digits, but also because increased inflation in the 1970s was not accompanied
by any improvement in unemployment or economic growth.13
The main difference between monetary policy in the pre-1979 and post-1979
eras was the responsiveness of policy to changes in inflation: after 1979, the Fed was
much more likely to quickly and sharply raise interest rates when inflation rose.
Economic theory is ambiguous as to whether this change would make growth more
or less volatile. On one hand, a policy that is less accommodative to changes in
inflation must, by definition, cause sharper changes in short-term growth since the
Fed changes inflation by altering interest rates to change the level of interest-sensitive
spending. And it is nearly tautological to say that a policy that focuses more on
stabilizing inflation must focus less on stabilizing growth. Indeed, the immediate
result of policy under Chairman Volcker was a sharp economic contraction. On the
other hand, many economists have stressed the importance of inflationary
expectations to economic performance over time. They argue that if the Fed is not
significantly responsive to changes in inflation, individuals would quickly come to
expect that inflation will rise. Once this happens, they argue, the Fed would no
longer be able to trade off higher inflation for higher economic growth, and monetary
policy would lose some of its effectiveness. Sharp increases in interest rates might
be needed to subsequently reduce inflationary expectations. Or the Fed might be
forced to make cumulatively larger rate increases down the road if an increase in
inflation is not nipped in the bud. If so, economic growth could become less, rather
12 Most economists believe that there is a natural rate of unemployment to which the
economy naturally tends to equilibrate, and if the Fed uses monetary policy to push actual
unemployment below the natural rate, inflation will rise. For more information, see CRS
Report RL30391, Inflation and Unemployment: What is the Connection?, by Brian W.
Cashell.
13 In addition, the Fed’s freedom to pursue price stability was constrained by the need to
maintain fixed exchange rates under the Breton Woods system until 1973.

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than more, stable. The key difference behind these views is a philosophical
disagreement over whether policy should be viewed as a corrective or disruptive
force in the economy.
Monetary policy affects the smoothness of the business cycle. Thus, the extent
to which better policy can take credit for the great moderation depends in part on
whether the great moderation is cyclical in nature. Here the evidence is mixed, with
McConnell and Perez-Quiros arguing the great moderation is not primarily the result
of a smoother business cycle, and Kim and Nelson arguing that it is.14 Figure 1
shows that a smoother business cycle cannot be the whole story because even from
one quarter to the next, random fluctuations (i.e., those that do not follow a cyclical
pattern) have been smaller.
Stock and Watson use different theoretical models to simulate how the economy
would have performed since the 1980s if the monetary policy used before 1979, when
Paul Volcker became Chairman of the Fed, had remained in place. By comparing
how the economy performed in the counterfactual case to how it actually performed,
they estimate how much of the great moderation was caused by the change in
monetary policy. They find that the change in policy either reduced volatility only
slightly, or in some simulations actually increased volatility.15
The volatility of inflation has also fallen since 1984. Blanchard and Simon
show that economic volatility tends to be high when inflation and inflation volatility
are high, and vice versa.16 Inflation volatility could cause economic volatility since
it blurs interest rate and price signals, which indicate to market participants how to
efficiently allocate financial and real resources, respectively. Fed Chairman Ben
Bernanke argues that the historical correlation between inflation volatility and
economic volatility is evidence that the great moderation is the result of better policy,
since the Fed strongly influences inflation.17 Bernanke suggests that policy may have
been so bad in the 1970s that, instead of the usual tradeoff between economic
volatility and inflation volatility, it raised both.
Blanchard and Simon point out that the correlation between inflation volatility
and economic volatility does not prove that better policy is the cause of the great
moderation. Alternatively, economic shocks could be causing economic volatility
and inflation volatility to move together. To determine whether shocks or policy is
14 Chang-Jin Kim and Charles Nelson, “Has the U.S. Economy Become More Stable?,”
Review of Economics and Statistics, vol. 81, no. 4, November 1999, p. 608; Margaret
McConnell and Gabriel Perez-Quiros, “Output Fluctuations in the United States: What Has
Changed Since the Early 1980s,” American Economic Review, vol. 90, no. 5, December
2000, p. 1464.
15 James Stock and Mark Watson, “Has the Business Cycle Changed?”, in Monetary Policy
and Uncertainty: Adapting to a Changing Economy, Federal Reserve Bank of Kansas City,
2003, p. 19.
16 Olivier Blanchard and John Simon, “The Long and Large Decline in U.S. Output
Volatility,” Brookings Papers on Economic Activity 1, 2001, p. 135.
17 Remarks by Ben Bernanke at the meetings of the Eastern Economic Association,
Washington, DC, February 20, 2004.

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the cause, they look at differences in volatility across countries to try to control for
shocks, and conclude that policy is still an important cause of the great moderation.
Similarly, Summers finds a link between lower inflation volatility and lower
economic volatility across different advanced economies, and argues that this is
evidence in favor of the “better policy” explanation.18
But Stock and Watson view the fact that the great moderation occurred across
all advanced economies as evidence that it was not policy related, unless all countries
simultaneously improved their policy.19 While it is difficult to measure an
improvement in policy quantitatively, they argue that policy regimes did not change
uniformly in different countries over time. For example, many economists believe
that political independence improves central banks’ policymaking.20 Britain’s central
bank eventually gained political independence from the Treasury in the 1990s, which
could potentially explain the reduction in its economic volatility. But Germany’s
central bank was highly independent all along, and it experienced the same reduction.
Economic volatility was high in the 1950s even though inflation was low. This
evidence seems at odds with the “better policy” explanation of the great moderation.
However, inflation volatility was high in the 1950s, which suggests that, if policy is
important, it is the volatility of inflation — not the level of inflation — that causes
economic volatility.
This section has focused on the role of macroeconomic policymaking in the
cause of the great moderation, but there are also microeconomic policy changes that
could have contributed to it. For example, Alan Greenspan has suggested that
deregulation of certain industries has made the economy more flexible and able to
absorb shocks. He also believes that mortgage market innovations such as the repeal
of regulation Q (which regulated bank interest rates), mortgage securitization,
mortgage innovations such as adjustable rate mortgages, and greater consumer access
to mortgage markets could explain the sharp relative decline in residential investment
volatility.21 Finally, President Nixon’s general wage and price controls could have
contributed to economic volatility in the 1970s by distorting the market allocation of
resources.
18 Peter Summers, “What Caused the Great Moderation?”, Federal Reserve Bank of Kansas
City, Economic Review, vol. 90, no. 3, July 2005, p. 2.
19 Japan is somewhat of an exception that supports the role of policy in reduced economic
volatility. While Japan’s economic volatility fell sharply in the 1980s, like other countries,
it rose somewhat in the 1990s, during the long recession that many economists ascribe to
bad policy decisions by the Japanese central bank.
20 For more information on central bank independence, see CRS Report RL31955, Central
Bank Independence and Economic Performance, by Marc Labonte and Gail E. Makinen.
21 Alan Greenspan, “Opening Remarks” and “Comments,” in Monetary Policy and
Uncertainty: Adapting to a Changing Economy, Federal Reserve Bank of Kansas City,
2003, p. 1 and p. 74.

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Better Luck
Although the period since 1984 covers 22 years, it may not be a representative
sample of the full range of random shocks that the economy will encounter over time.
A period of 22 years may sound lengthy, but the period since 1984 covers only one
entire expansion and parts of two others, along with two mild and brief recessions.
It may be that the economy was unusually lucky over this period, in the sense that it
experienced an unusually low number of the harmful shocks that often lead to
recessions. If so, it could be that nothing fundamental has changed in the economy
that would make one expect the great moderation to continue in the future. (Findings
such as the decline in the volatility of residential investment since 1984 may already
be put to the test by recent events.) Likewise, the economy may have experienced
unusually bad luck in the 1970s and early 1980s, given that the period included two
deep recessions (and a third which was milder) that may be driving the overall
results.
Stock and Watson conclude that better luck may have been the most important
factor behind the great moderation. They demonstrate this by simulating how the
post-1984 economy would have performed if faced with pre-1984 shocks, and show
that it would have been just as volatile.22 Unfortunately, shocks are identified in their
model (as in most models) in a generic sense, which makes it difficult to understand
what caused the shocks and whether or not they were avoidable. Two possibilities
are oil shocks and productivity shocks, although identifying a productivity shock
does little to help explain what caused it. In the case of oil, evidence suggests that
the economy has still experienced shocks, but it seems to have gotten better at coping
with them.23 The most recent oil shock, for example, did not result in a recession,
unlike its historical predecessors.
Ahmed, Levin, and Wilson also argue that good luck was the most important
cause of the great moderation. They demonstrate statistically that the reduction in
volatility is found over any length of time that is chosen, and argue that this pattern
is most consistent with good luck. They argue that if good policy were the cause, it
would lead to a smoother business cycle, and if structural change were the cause, it
would lead to less volatility at the quarterly level.24 Since they do not identify the
causes directly, however, their conclusions depend on how the data are interpreted.
22 James Stock and Mark Watson, “Has the Business Cycle Changed?,” in Monetary Policy
and Uncertainty: Adapting to a Changing Economy, Federal Reserve Bank of Kansas City,
2003, p. 19.
23 See CRS Report RL31608, The Effects of Oil Shocks on the Economy, by Marc Labonte.
Summers finds evidence that oil shocks did not coincide with the great moderation in several
other advanced economies, casting doubt on the better luck theory. Peter Summers, “What
Caused the Great Moderation?,” Federal Reserve Bank of Kansas City, Economic Review,
vol. 90, no. 3, July 2005, p. 2.
24 Shagil Ahmed, Andrew Levin, and Beth Wilson, “Recent U.S. Macroeconomic Stability:
Good Policies, Good Practices, or Good Luck?,” Federal Reserve, International Finance
Discussion Series #730, July 2002. In addition, they find that better inventory management
may have played a secondary explanatory role.

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For example, their evidence could mean that both better policy and structural change
caused the great moderation.
Perhaps the main argument against the better luck explanation, at least in terms
of why recessions have become less frequent, is the fact that even during expansions
there has been a large decline in volatility since 1984, as can be seen in Figure 1.
Friedman argues that the “better luck” explanation may be a reflection of the
economic models being used. In many of these models, “exogenous shocks” (e.g.,
shocks that are not influenced by the variables in the model) are not identified ex
ante; instead, they are defined ex post as residual fluctuations in economic growth
that cannot be explained by the models’ endogenous variables. Because the models
fail to explain much of the volatility in economic activity, better luck is credited for
the great moderation by default. Rather than conclude that shocks are most
important, another interpretation is that the real cause is still unknown.25
Chairman Bernanke questions whether the role of better luck in the great
moderation has been overestimated.26 He argues that what might appear to be the
result of better luck is actually related to better policy — that a good policy
environment is conducive to stability, and that it is no coincidence that in a bad
policy environment things tend to go wrong. He notes that the economy has been
able to shrug off several shocks in recent years — including the Asian financial
crisis, September 11, the stock market decline, and the recent oil shock — that in the
past would have been expected to cause a recession, and believes that good policy
partly explains why. Greenspan points out that since the shocks are being measured
as changes in growth ex post, it may not be the case that the shocks are smaller, but
rather that the economy is now better able to shrug them off because it has become
more flexible, in part due to policy improvements.27
The 2008 Slowdown and the Great Moderation:
An Exception That Proves the Rule?
The economic slowdown beginning in the fourth quarter of 2007 and extending
into 2008 has been seen by many as evidence that the great moderation has ended.
But a closer look at the evidence suggests that, on the contrary, recent events are
consistent with the great moderation theory.
Since the second half of 2007, the economy has been hit by three negative
shocks of a serious nature: a housing downturn, resulting financial turmoil, and an
25 Benjamin Friedman, “Comment,” Brookings Papers on Economic Activity 1, 2001, p. 165.
26 Remarks by Ben Bernanke at the meetings of the Eastern Economic Association,
Washington D.C., February 20, 2004.
27 Alan Greenspan, “General Discussion,” in Monetary Policy and Uncertainty: Adapting
to a Changing Economy, Federal Reserve Bank of Kansas City, 2003, p. 74.

CRS-11
oil shock.28 By some measures, all of these shocks could be argued to be the worst
of their kind since the Great Depression: until now, housing prices have not fallen in
nominal terms, financial markets have not experienced months of continuous turmoil,
and oil prices have never risen as high in inflation-adjusted terms. Any one of these
shocks in isolation had the potential to cause a recession, and when all three occurred
simultaneously, many economists predicted that it would drive the economy into a
recession. And yet, to date, economic growth fell only slightly in the fourth quarter
of 2007, and has remained positive in 2008. While residential investment has
declined precipitously, to date, the shocks have not spread to a broad decline in
economic activity throughout the rest of the economy. Figure 2 illustrates that
recessions between 1945 and 1984 tended to be longer, deeper, and more frequent
than since the Great Moderation began. Compared to these recessions, the slowdown
since the fourth quarter of 2007 looks very mild indeed. Employment has fallen in
2008, but also at a slower pace than is usually experienced in recessions thus far.
Figure 2. Cumulative Change in GDP in Post-War Recessions
and Since 2007.4
1949.1- 1953.3- 1957.4- 1960.2- 1969.4- 1973.3- 1980.2- 1981.2- 1990.3- 2001.1- 2007.4-
1949.4 1954.1 1958.1 1960.4 1970.1 1975.1 1980.3 1982.3 1991.1 2001.3 2008.2
0.5
-0.002 0.006
0
-0.5
e
-0.6
g
-1
an -1.5
-1.3
t ch
-2
-1.7
-1.6
rcen -2.5
-2.2
e
-2.3
p
-3
-2.7
-2.7
-3.5
Great Moderation
-4
-3.7
Source: CRS calculations based on data from the Bureau of Economic Analysis.
Cast in this light, the fact that the slowdown has been so mild can be seen as
evidence supporting the “great moderation” theory. Furthermore, it may weaken the
“better luck” explanation — few would characterize the three shocks that the
economy has faced as good luck. Either the “structural change” (a more flexible
economy has been able to adjust to the shocks quickly) or “better policy” (timely
fiscal and monetary stimulus were able to offset the shocks) explanations could be
consistent with recent experience.
28 For more information, see CRS Report RL34484, Evaluating the Potential for a Recession
in 2008, by Marc Labonte.

CRS-12
Policy Implications
The policy implications of the great moderation depend on its cause. If it was
caused primarily by structural changes, it can be seen as an additional,
unacknowledged benefit of the long-term policy shift toward greater deregulation and
tolerance for marketplace innovation. This conclusion may run counter to
conventional wisdom, which typically views a greater reliance on market forces as
leading to more, not less, economic uncertainty. Alternatively, if the great moderation
was primarily the result of better monetary policy, Congress can support or even
attempt to institutionalize recent monetary policy practices. But if the great
moderation is simply the result of better luck, then policymakers may want to guard
against complacency, and could even take the opportunity to stockpile resources for
a rainy day (by reducing the budget deficit, for example) while times are good.