1. What Caused the Decline in U. S. Business Cycle Volatility? Robert J. Gordon Northwestern University Presented at Reserve Bank of Australia, July 11, 2005

2. Instant Obsolescence in Macroeconomics Prosperity in 1960s bred conferences on “Is the Business Cycle Obsolete?” Prosperity in 1960s bred conferences on “Is the Business Cycle Obsolete?” My 1984 conference came after the two large recessions of 1974-75 and 1981-82 My 1984 conference came after the two large recessions of 1974-75 and 1981-82 But on the day of the conference, the business cycle changed again, continuing the tradition of “instant obsolescence” But on the day of the conference, the business cycle changed again, continuing the tradition of “instant obsolescence” No disputing the decline in volatility since 1984, but why? No disputing the decline in volatility since 1984, but why? Numerous participants in last week’s Fed conference took it for granted that it was an achievement of monetary policy Numerous participants in last week’s Fed conference took it for granted that it was an achievement of monetary policy

3. Earlier Explanations of Postwar Stability Compared to pre-1929 Increased share of government, higher tax base creates automatic stabilizers Increased share of government, higher tax base creates automatic stabilizers Less procyclicality of money supply Less procyclicality of money supply FDIC, Other Financial Market Reforms FDIC, Other Financial Market Reforms

4. Stabilization within Postwar, before and after 1984 Shocks Shocks Demand shocks Demand shocks Federal government now the culprit not the saviourFinancial and banking reforms Federal government now the culprit not the saviourFinancial and banking reforms Inventory management Inventory management Financial Market Deregulation stabilized residential housing Financial Market Deregulation stabilized residential housing Supply shocks, a main focus of this paper Supply shocks, a main focus of this paper Improved monetary policy Improved monetary policy Of Lesser Importance Of Lesser Importance Shifts in shares to services Shifts in shares to services

5. Preview of Paper Composition analysis across 11 components of spending on GDP Composition analysis across 11 components of spending on GDP Role of composition shifts vs. reduction in within- sector volatility Role of composition shifts vs. reduction in within- sector volatility Isolation of three sectors as most responsible for improved stability; support for demand shocks Isolation of three sectors as most responsible for improved stability; support for demand shocks Building a three-equation macro model Building a three-equation macro model Inflation, Taylor Rule, Change in Output Gap Inflation, Taylor Rule, Change in Output Gap In the spirit of Stock-Watson two papers, but a more explicit interpretation of the shocks and a surprising result about monetary policy In the spirit of Stock-Watson two papers, but a more explicit interpretation of the shocks and a surprising result about monetary policy

6. Initial Evidence on Reduced Volatility (4-qtr Δ Real GDP)

7. Rolling 20-quarter Standard Deviation of 4-qtr Δs in Real GDP, 2.8 vs. 1.3 pre/post 1988:Q1

8. What About Changes in Natural Output Growth? A Better Criterion: the Output Gap

9. Stability Less Obvious but Still Significant, Decline 42% vs. 57%

10. Inflation vs. Output Volatility: Sometimes the Same, but Other Times Different

11. Turn to Tables for Decomposition Analysis Table 1: Standard Deviations and Shares of 11 Sectors Table 1: Standard Deviations and Shares of 11 Sectors Table 2: Effect of Shifts in Shares and Own-Sector Volatility Table 2: Effect of Shifts in Shares and Own-Sector Volatility Table 3: Contributions to GDP Change: Table 3: Contributions to GDP Change: Emphasis on Residential Investment, Inventory Investment, and Federal Spending Emphasis on Residential Investment, Inventory Investment, and Federal Spending

12. Building the Three Equation Model Combines my “mainstream” or “triangle” approach to explaining inflation Combines my “mainstream” or “triangle” approach to explaining inflation Inertia Inertia Demand through output or U gap Demand through output or U gap Specific supply shocks Specific supply shocks “Taylor Rule” equation for Fed Funds rate “Taylor Rule” equation for Fed Funds rate Coefficients allowed to change, 1979 and 1990 Coefficients allowed to change, 1979 and 1990 Output gap equation with feedback from interest rate changes Output gap equation with feedback from interest rate changes

13. The Inflation Equation: the Distinguishing Features Long 24-quarter lags on past inflation Long 24-quarter lags on past inflation No pretense that these represent expectations – some unknown combination of expectations, wage contracts, price contracts No pretense that these represent expectations – some unknown combination of expectations, wage contracts, price contracts Demand enters through the unemployment gap Demand enters through the unemployment gap Time-varying NAIRU estimated as part of equation estimation Time-varying NAIRU estimated as part of equation estimation “No-shock” concept of NAIRU “No-shock” concept of NAIRU

14. Supply-shock variables Changes in the relative price of imports Changes in the relative price of imports The food-energy effect The food-energy effect The medical care effect The medical care effect Acceleration and deceleration of the productivity growth trend Acceleration and deceleration of the productivity growth trend Nixon-era controls, held down inflation in 1971-72, boosted inflation in 1974 Nixon-era controls, held down inflation in 1971-72, boosted inflation in 1974

15. Changes in Relative Import Prices

16. The Food-Energy Effect

17. The Medical Care Effect

18. The Productivity Growth Trend Acceleration

19. Actual Unemployment Rate and the Time-Varying NAIRU (TVN)

20. Coefficients of Inflation Equation are in Table 4 Brief Comments on Size and Sign of Coefficients Brief Comments on Size and Sign of Coefficients Importance of Testing Inflation Coefficients with Dynamic Simulations Importance of Testing Inflation Coefficients with Dynamic Simulations Results in Bottom of Table 4: Estimate coefficients through 1994:Q4, simulation 1995:Q1 to 2004:Q4 (40 quarters) Results in Bottom of Table 4: Estimate coefficients through 1994:Q4, simulation 1995:Q1 to 2004:Q4 (40 quarters) Qualification: The Simulation Knows the Time-Varying NAIRU Qualification: The Simulation Knows the Time-Varying NAIRU

21. A Longer Simulation: 160 Quarters Knowing the TVN and the full-period coefficients

22. The Dramatic Effect of Supply Shocks

23. The Interest Rate Equation R = T* + p* + a(p-p*) + b(Ygap) R = T* + p* + a(p-p*) + b(Ygap) Estimated over three time intervals Estimated over three time intervals 1960-79 1960-79 1979-90 1979-90 1990-2004 1990-2004 Coefficients presented in Table 5 Coefficients presented in Table 5 After 1979, Fed fought inflation After 1979, Fed fought inflation After 1990, Fed fought both infl & Ygap After 1990, Fed fought both infl & Ygap

24. Actual and Predicted Values of Fed Funds Rate

25. Interest Rate Error: Sustained after 1994 Estimated Error Term

26. The Output Gap Equation First Difference of Output Gap regressed on First Difference of Output Gap regressed on First Difference of Inflation Rate First Difference of Inflation Rate First Difference of Lagged Nominal Fed Funds Rate, quarters 2-10 (why?) First Difference of Lagged Nominal Fed Funds Rate, quarters 2-10 (why?) Real vs. Nominal Rates? Real vs. Nominal Rates? An Central Concept in the Paper: An Central Concept in the Paper: “The Output Error” “The Output Error”

27. Predicted Output Values Miss, Especially after 1990

28. Full Model Simulations: Table 7 Here is Inflation

29. Full-Model Simulation of the Federal Funds Rate (Split Sample)

30. The Basic Conclusion of the Paper: The Output Gap Simulations

31. Bottom of Table 7: Summary of Output Gap Conclusions Standard Deviation of Output Gap Standard Deviation of Output Gap Absolute Value of Output Gap Absolute Value of Output Gap Supply Shocks and the Output Error were Supply Shocks and the Output Error were Roughly equal culprits No Role of Interest-rate Error No Role of Interest-rate Error

32. Effects of Changes in Monetary Policy Feedback Responses

33. Conclusions Demand and Supply Shocks both Mattered Demand and Supply Shocks both Mattered The Major Demand Shocks were Military Spending, Financial Institutions that Destabilized Residential Investment, and Primitive Inventory Management The Major Demand Shocks were Military Spending, Financial Institutions that Destabilized Residential Investment, and Primitive Inventory Management The Major Supply Shocks were Import Prices (and Flexible Exchange Rates), Food-Oil Prices, Medical Care Prices, Productivity Trend, and Nixon Controls The Major Supply Shocks were Import Prices (and Flexible Exchange Rates), Food-Oil Prices, Medical Care Prices, Productivity Trend, and Nixon Controls

34. Role of Monetary Policy Accommodative Policy in the 1970s Allowed Inflation to Take off Accommodative Policy in the 1970s Allowed Inflation to Take off Made 1981-82 Recession Worse Made 1981-82 Recession Worse Volcker Post-1979 Monetary Policy Created Instability Volcker Post-1979 Monetary Policy Created Instability Best Policy of All: Greenspan Policy applied to entire postwar period! Best Policy of All: Greenspan Policy applied to entire postwar period! Combined inflation and output target beats a pure inflation target by every criterion Combined inflation and output target beats a pure inflation target by every criterion