What Is the Great Moderation?
The Great Moderation refers to a period of remarkable macroeconomic stability in the United States, spanning from the mid-1980s until the onset of the 2007–2008 financial crisis. Characterized by low and stable inflation, reduced volatility in Gross Domestic Product (GDP) growth, and fewer, milder recessions, this era represented a significant shift from the economic turbulence of the preceding decades. It falls under the broad categories of macroeconomics and financial history, deeply influencing economic policy and theory during its tenure. The Great Moderation saw consistently positive economic growth and was a period where central banks gained significant credibility in managing the economy.
History and Origin
The term "Great Moderation" was coined by economists James H. Stock and Mark W. Watson in their 2002 paper, "Has the Business Cycle Changed and Why?" Former Federal Reserve Chair Ben Bernanke later popularized the term in a 2004 speech, attributing the stability to improved monetary policy, structural changes in the economy, and good fortune. This period followed the "Great Inflation" of the 1970s and early 1980s, which was marked by high and volatile inflation rates. Under the leadership of Federal Reserve Chair Paul Volcker, aggressive measures were taken to bring inflation under control, laying the groundwork for the stability that followed. 11, 12Subsequent chairs, Alan Greenspan and Ben Bernanke, continued policies that fostered this environment of low and stable prices, contributing to an extended economic expansion.
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Key Takeaways
- The Great Moderation was a period of reduced macroeconomic volatility in the U.S. from the mid-1980s to 2007.
- It was characterized by low and stable inflation and milder business cycles.
- Attributed factors include improved monetary policy, structural economic changes, and, to some extent, good luck.
- The period ended with the 2007–2008 financial crisis and the subsequent Great Recession.
- The Great Moderation fostered a sense of complacency regarding financial risk-taking.
Interpreting the Great Moderation
The Great Moderation represented a significant departure from previous economic patterns, leading many economists and policymakers to believe that better economic management had fundamentally altered the business cycle. This period allowed for sustained prosperity and investment, as businesses and consumers faced less uncertainty about future economic conditions and interest rates. The perceived success of monetary policy in taming inflation and moderating economic swings led to increased confidence in central bank capabilities. Ho9wever, this prolonged period of calm also led to a degree of complacency, particularly within the financial sector, regarding the build-up of systemic risks.
Imagine a long-term investor planning for retirement during the Great Moderation. Before this period, unpredictable inflation and frequent, severe recessions made long-term financial planning challenging. During the Great Moderation, with stable prices and consistent, moderate economic growth, the investor could more confidently project the real value of their future savings and investment returns. This stability might lead them to allocate a larger portion of their portfolio to riskier assets, assuming that the benign economic environment would continue, leading to sustained gains and minimizing significant downturns. The reduced market volatility during this time made it easier for individuals to plan their retirement savings and consider various investment strategies.
Practical Applications
The concept of the Great Moderation has practical applications in understanding economic policy and investor behavior. It highlights how prolonged periods of stability, while beneficial in many respects, can inadvertently lead to excessive leverage and risk-taking within the financial system. Policymakers study the Great Moderation to understand the interplay between monetary policy, financial innovation, and systemic risk. For instance, the Federal Reserve's actions during this time are often analyzed to identify how stable economic conditions contributed to an environment where financial institutions might have underestimated risks, leading to vulnerabilities that culminated in the 2008 crisis. Th6is era also informs discussions on macroprudential policies aimed at preserving financial stability during good times.
#5# Limitations and Criticisms
Despite its name, the Great Moderation was not without its limitations and criticisms, particularly in hindsight. One significant critique is that the prolonged period of stability may have fostered excessive complacency and a mispricing of risk in financial markets. Th3, 4is "search for yield" led investors to take on more risk in pursuit of higher returns, contributing to the formation of asset bubbles, particularly in the housing market, which ultimately burst and triggered the 2007–2008 financial crisis.
Som2e economists argue that while macroeconomic volatility decreased, financial volatility might have increased, leading to a build-up of systemic risk. The emphasis during the Great Moderation was primarily on controlling inflation and stabilizing output, with less focus on monitoring and mitigating financial excesses. The 1eventual end of the Great Moderation with the global financial crisis demonstrated that even periods of apparent stability can conceal underlying vulnerabilities, leading to discussions in behavioral economics about how human psychology reacts to extended periods of calm markets, potentially leading to herd mentality and irrational exuberance concerning asset prices.
Great Moderation vs. Financial Crisis
The Great Moderation is often discussed in direct contrast to the financial crisis that followed it. The Great Moderation represents a period of perceived calm and stability in macroeconomic indicators, characterized by low inflation and mild recessions. During this time, the prevailing sentiment was that central banks had mastered economic management. In stark contrast, the financial crisis, particularly the 2007–2008 subprime mortgage crisis and its global fallout, marked an abrupt and severe end to this period. While the Great Moderation was defined by reduced volatility and a sense of economic control, the financial crisis was a period of extreme financial dislocation, systemic risk, and the deepest global recession since the Great Depression. The crisis exposed vulnerabilities that many argue were allowed to fester during the "comfortable environment" of the Great Moderation due to a lack of vigilance regarding financial sector risks.
FAQs
What was the primary characteristic of the Great Moderation?
The primary characteristic of the Great Moderation was a significant reduction in macroeconomic volatility in the U.S., marked by low and stable inflation and less frequent, milder recessions.
When did the Great Moderation take place?
The Great Moderation generally refers to the period from the mid-1980s until the onset of the 2007–2008 global financial crisis.
What caused the Great Moderation?
Economists generally attribute the Great Moderation to a combination of factors, including improved monetary policy, structural changes in the economy (such as better inventory management), and, to some extent, good fortune.
How did the Great Moderation end?
The Great Moderation is widely considered to have ended with the eruption of the 2007–2008 financial crisis and the subsequent Great Recession, which exposed underlying risks and vulnerabilities that had accumulated during the period of calm.
What lessons can be learned from the Great Moderation?
The Great Moderation highlights that prolonged periods of macroeconomic stability can inadvertently lead to increased financial risk-taking and complacency within the financial system. It underscores the importance of vigilantly monitoring systemic risks even during benign economic times.