Gali and Gambetti On the Sources of the Great Moderation Good luck? ………. No major shocks Good practice? … JIT inventory management Production smoothing Financial innovations – risk sharing Good policy? ……. Inflation targeting – Taylor Rule: - oppose demand-side shocks - accommodate supply shocks

Output = Hours x Productivity Figure 1A. Output volatility – decline in early 1980s » Hours volatility down most sharply  smoothing

Output = Hours x Productivity Figure 1A. Output volatility – decline in early 1980s » Hours volatility down most sharply  smoothing Figure 1B.Output volatility down more than its components

Output = Hours x Productivity Figure 1A. Output volatility – decline in early 1980s » Hours volatility down most sharply  smoothing Figure 1B.Output volatility down more than its components : An explanation :

Output = Hours x Productivity Figure 1A. Output volatility – decline in early 1980s » Hours volatility down most sharply  smoothing Figure 1B.Output volatility down more than its components : An explanation : Figure 2. Hours – Productivity correlation switched from positive to negative in 1980s ρ pre-1984 =.18 ρ post-1984 = -.41 » Challenges RBC theory: when productivity up, hours ought to rise

Decomposing Shocks Technology shocks (= “supply-side” shocks) persist Non-tech shocks (residuals = “demand-side”) revert

Decomposing Shocks Technology shocks (= “supply-side” shocks) persist Non-tech shocks (residuals = “demand-side”) revert Volatility conditional on tech- and non-tech shocks – Output volatility conditioned on tech-shocks: modest decline – Output volatility conditioned on non-tech shocks: sharp decline

Decomposing Shocks Technology shocks (= “supply-side” shocks) persist Non-tech shocks (residuals = “demand-side”) revert Volatility conditional on tech- and non-tech shocks – Hours volatility conditioned on non-tech shocks: sharp decline

Decomposing Shocks Technology shocks (= “supply-side” shocks) persist Non-tech shocks (residuals = “demand-side”) revert Volatility conditional on tech- and non-tech shocks – Output volatility conditioned on tech-shocks: modest decline – Output volatility conditioned on non-tech shocks: sharp decline – Hours volatility conditioned on non-tech shocks: sharp decline  supports policy view, unless non-tech shocks themselves small  rejects RBC view that tech-shocks matter most

Decomposing Shocks Technology shocks (= “supply-side” shocks) persist Non-tech shocks (residuals = “demand-side”) revert Volatility conditional on tech- and non-tech shocks – Fluctuations in productivity largely accounted for by tech-shocks, as would be expected

Correlations conditional on tech- and non-tech shocks Focus on Hours – Productivity Correlation – Non-tech explains drop in Hours – Productivity correlation after 1990, i.e., after onset of Great Moderation – Consistent negative contribution of tech shocks  increased relative importance of tech shocks  decreased relative importance of non-tech shocks

Correlations conditional on tech- and non-tech shocks Focus on Hours – Productivity Correlation – Decline in Hours – Productivity correlation in late period is conditional on non-tech shocks Conclude: “Good policy” response to small non-tech shocks  Great Moderation

Implications and Conclusions “Good policy” response to small non-tech shocks  Great Moderation High and positive Hours – Productivity correlation conditional on non-tech, demand-side shocks in early period explained by labor hoarding – Increased labor market flexibility in late period  Reduced labor hoarding  Great Moderation Sources of the Great Moderation Good policy Good practice Not luck But now an update …