Monetary Policy and the Great Moderation in Macro Volatility

1
Monetary Policy and the Great Moderation in Macro
Volatility

• ECGA 7020 Special Topic Presentation
• Dan Maolusi Fall 2005
• Fordham University

2
Evidence

• GDP growth Std Dev decreases
• Pre-1984 moving quarterly Std dev was about 4.7
• Since 1984 moving quarterly Std dev fell to
  about 2.1

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Std Dev of Quarterly U.S. GDP Growth Source
Anesto and Piger (2005) International Economic
Trends August.
4
Causes and Explanations

• Three broad Explanations
• Improved Macro Policy
• Structural Change
• Good Luck
• All three explanations have been explored in
  literature
• I focus on 1 better Macro Policy

5
Monetary Policy Rules and Macroeconomic
Stability Evidence and Some Theory

• Clarida et. All (2000) argue improved monetary
  policy let to the great moderation
• Estimate a Forward looking monetary policy
  reaction function for two eras
• 601-792 and 793-964

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Standard Deviation of Inflation and output pre
and post Volcker
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Causes of declined Volatility

• The decline in volatility appears substantial for
  each variable
• The decline in volatility is more substantial
  when Volcker-Greenspan starts in 824, after the
  Volcker disinflation

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Taylor Rule for Fed Policy

• where the target rate for the nominal
  Federal Funds rate in period t
• the percentage change in the price level
  between periods t and tk
• the target inflation
• a measure of the average output gap between
  period t and tq
• the information set at the time the interest
  rate is set.
• is an exogenous interest rate shock

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Taylor Rule Estimates

• Table shows estimates of Fed response to expected
  inflation, , Column B and Fed response to
  GDP gap, , Column C
• Standard errors are in parenthesis

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• Column B Volcker-Greenspan more responsive than
  pre-Volcker and therefore stabilizing since beta
  is greater than 1
• Column C Volcker-Greenspan significantly greater
  than pre-Volcker, thus more responsive and
  stabilizing

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Differences in Policy Rules

• Differ in terms of response to expected inflation
• Pre-Volcker short term rates allowed to fall
  with a rise in expected inflation
• Fed would raise nominal rates but by less than
  the rise in expected inflation
• Thus less pro-active policy in pre-Volcker

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Differences in Policy Rules

• Volcker-Greenspan real and nominal short term
  rates raised in response to higher expected
  inflation
• Thus more proactive policy
• Pre-Volcker less effective since it allows
  macroeconomic instability
• Permits bursts in inflation and output
• Less effective in mitigating shocks to economy

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Actual vs. Target interest rate
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