Economics 1490 GROWTH AND CRISIS IN THE WORLD ECONOMY with Professor Dale W. Jorgenson Lecture 06: September 22, 2015 The Great Moderation Harvard University Department of Economics - Fall 2015

Lecture 06: September 22, 2015 The Great Moderation Course Outline 1. Introduction 2. U.S. Financial and Economic Crisis. 3. Europe and the U.S.: Convergence and Divergence. 4. Asian Economic Miracles. 5. Sustainability of Economic Growth. 6. Outlook for the World Economy.

U.S. Financial and Economic Crisis 6. The Great Moderation. 7. The U.S. Financial Crisis. 8. Monetary Policy. 9. Financial Regulation: Micro-Prudential and Macro-Prudential. 10. Fiscal Policy. Lecture 06: September 22, 2015 The Great Moderation

SUPPLEMENTARY READING John B. Taylor, "What Went Right in the Two Decades before the Crisis," Chapter 4 in Getting Off Track, Stanford, Hoover Institution Press, pp Ben Bernanke, "The Taylor Rule: A benchmark for monetary policy?" Ben Bernanke's Blog, April 28, See: bernanke/posts/2015/04/28-taylor-rule-monetary- policyhttp:// bernanke/posts/2015/04/28-taylor-rule-monetary- policy Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation BEN S. BERNANKE BIOGRAPHY 14th Chairman of the Federal Reserve, Sworn In February 1, Born Augusta, Georgia, December 13, 1953; Raised in Dillon, South Carolina. Harvard College, B.A. in Economics, summa cum laude, in Resided in Winthrop House. MIT Ph.D. in Economics in Taught at Stanford Business School and Princeton University. Member of the Federal Reserve Board of Governors, Chairman of the President’s Council of Economic Advisers under George W. Bush, 2005 until appointment as Chairman of the Fed.

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation JOHN B. TAYLOR BIOGRAPHY Mary and Robert Raymond Professor of Economics, Stanford University. Born in Yonkers, New York, December 8, Princeton University, B.A. in Economics, summa cum laude, in Stanford University, Ph.D. in Economics, in Taught at Columbia, Princeton, and Stanford. Member of the President’s Council of Economic Advisers under George H.W. Bush, Undersecretary for International Affairs,

Lecture 06: September 22, 2015 The Great Moderation WHAT WENT RIGHT IN THE TWO DECADES BEFORE THE CRISIS Mission Impossible I: Reduce Inflation and Output Volatility Around the World. Result: The Great Moderation. Mission Impossible II: Reduce the Frequency and Global Spread of Financial Crises. Result: The End of the Eight-Year Crisis. Mission Impossible III: Prevent the Forces of Globalization from Reversing the Missions Already Accomplished. Result: Too Soon to Tell.

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation Bernanke’s View of the Great Moderation: Structural Change “ … improved management of business inventories, made possible by advances in computation and communication, has reduced the amplitude of fluctuations in inventory stocks, which in earlier decades played an important role in cyclical fluctuations. 3 The increased depth and sophistication of financial markets, deregulation in many industries, the shift away from manufacturing toward services, and increased openness to trade and international capital flows are other examples of structural changes that may have increased macroeconomic flexibility and stability.” 3

Lecture 06: September 22, 2015 The Great Moderation Bernanke’s View of the Great Moderation: Monetary Policy Improved Performance of Macroeconomic Policies: Few disagree that monetary policy has played a large part in stabilizing inflation, and so the fact that output volatility has declined in parallel with inflation volatility, both in the United States and abroad, suggests that monetary policy may have helped moderate the variability of output as well. Good Luck! “… the shocks hitting the economy became smaller and more infrequent.”

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation The Taylor Rule The Fed or any other central bank should set the short-term interest rate and one-and-half times the inflation rate plus one-half times the GDP gap (actual minus potential output) plus one. The Fed should raise the interest rate when inflation increases and lower it when GDP declines, as in a recession. Example: In 1989 when the short- term federal funds rate was about 10 percent in the U.S., the 10 percent was equal to 1.5 times the inflation rate of 5 percent (7.5) plus one-half times the GDP gap of 3 percent (1.5) plus one. The rule was not designed for forecasting; it was meant to be normative, not positive, yet it turned out to be both. (Paraphrased from “Frequently Asked Questions” in Taylor’s book.)

Lecture 06: September 22, 2015 The Great Moderation EVIDENCE ON THE GREAT MODERATION Stock and Watson attach more significance to the “good luck” hypothesis. In his speech on the Great Moderation, Bernanke argues that more weight should be given to improvements in monetary policy: “I have suggested that some of the effects of improved monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks. This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s.” Taylor largely agrees with Bernanke; but augments the argument by introducing Mission Impossible II, which reduces international shocks. The reinforces Bernarke’s arguments by making part of the “good luck” endogenous.

Lecture 06: September 22, 2015 The Great Moderation TAYLOR’S ARGUMENT ON MISSION IMPOSSIBLE II IMF policy during the crisis period was unpredictable. In early 2003 the IMF introduced the exceptional access agreement (EAF): The G7 said in April 2002 that “we are prepared to limit official sector lending to normal access levels except when circumstances justify an exception.” The EAF spells out the conditions for exceptional access. The collective action clauses (CAC) adopted by Mexico in issuing bonds in February 2003 made it possible for sovereign borrowers to restructure their debt without borrowing from the IMF. Mission Impossible III: Getting back on track.

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation

Lecture 06: September 22, 2015 The Great Moderation

THE GREAT MODERATION: SUMMARY Mission Impossible I: Reduce Inflation and Output Volatility around the World. This Resulted in the Great Moderation. Mission Impossible II: Reduce the Frequency and Global Spread of Financial Crises. This Worked until Mission Impossible III: Prevent the Forces of Globalization from Reversing Reversing the Missions Already Accomplished. Mission Impossible IV: Get Back on Track. How Do We Do This? Lecture 06: September 22, 2015 The Great Moderation