What Is Great Moderation?
The Great Moderation refers to a period of reduced macroeconomic volatility in many advanced economies, particularly the United States, that began in the mid-1980s and lasted until the 2007–2009 financial crisis. During this era, key economic indicators such as economic growth and inflation exhibited significantly less variability compared to previous decades. This stability marked a notable shift in the business cycle and is often discussed within the broader field of macroeconomics.
History and Origin
The term "Great Moderation" was coined in 2002 by economists James H. Stock and Mark W. Watson to describe the observed decline in business cycle volatility. The phenomenon gained widespread attention, particularly after a speech delivered by Ben S. Bernanke, then a member of the Board of Governors of the Federal Reserve, in February 2004. In his speech, Bernanke highlighted the striking reduction in the variability of both output and inflation over the preceding two decades, noting that similar declines had occurred in other major industrial countries. T11, 12his period of relative tranquility followed decades of significant economic turbulence, including the high inflation and volatile interest rates of the 1970s and early 1980s. The Great Moderation is generally considered to have been a welcome period of calm after the volatility of the Great Inflation.
10## Key Takeaways
- The Great Moderation was a period of significantly reduced macroeconomic volatility in advanced economies from the mid-1980s to 2007.
- It was characterized by lower and more stable inflation, along with milder and less frequent economic recessions.
- Economists generally attribute the Great Moderation to a combination of improved monetary policy, structural changes in the economy, and, potentially, good economic luck.
- The period concluded with the onset of the 2007–2009 global financial crisis and the subsequent Great Recession.
- The end of the Great Moderation led to debates about its true causes and whether the stability it represented was sustainable.
Interpreting the Great Moderation
The Great Moderation represented a significant improvement in macroeconomic performance, making economic planning easier for households and firms. The9 observed decline in volatility meant that periods of economic expansion were longer and recession shorter and shallower than in previous eras. For instance, the standard deviation of quarterly real Gross Domestic Product (GDP) growth reportedly declined by half, and inflation variability by two-thirds during this period. This enhanced stability was widely perceived as a triumph of modern monetary policy, particularly the more systematic approach adopted by central banks in managing inflation and output. The ability of the central bank to maintain price stability while supporting sustained growth became a defining characteristic of the era.
Hypothetical Example
Consider an economy before the Great Moderation, where annual GDP growth swung wildly, perhaps from +8% one year to -3% the next, and inflation fluctuated between 2% and 15%. This extreme volatility creates uncertainty for businesses planning investments and for individuals making long-term financial decisions.
During the Great Moderation, the same economy might see GDP growth consistently between +2% and +4%, with inflation holding steady around 2-3%. While minor fluctuations still occur, the predictability of these key economic variables allows businesses to forecast demand more accurately and households to plan their budgets and savings with greater confidence. For example, a manufacturing company can invest in a new plant with more assurance that steady demand will justify the capital expenditure, leading to sustained job creation rather than boom-bust employment cycles.
Practical Applications
The relative calm of the Great Moderation significantly influenced how policymakers and investors approached risk management. For policymakers, the period reinforced the belief that effective monetary policy could significantly dampen the amplitude of the business cycle. Central banks, including the Federal Reserve, were seen as having successfully navigated complex economic conditions to achieve greater stability. This era also saw the rise of more systematic policy frameworks, such as the Taylor rule, which provided guidelines for setting interest rates based on inflation and output gaps.
Fo8r investors, the reduced macroeconomic volatility contributed to a period often characterized by lower equity risk premiums and steadier returns, influencing portfolio construction and asset allocation strategies. The period's stability, however, also prompted some critiques that it encouraged excessive risk-taking in financial markets, as the perception of low systemic risk might have led to increased leverage and less stringent lending standards.
##7 Limitations and Criticisms
While widely acknowledged for its economic benefits, the Great Moderation also faced limitations and criticisms, particularly in hindsight after the 2007–2009 financial crisis. One major critique is that the apparent stability may have fostered a false sense of security, leading to increased risk-taking and the buildup of imbalances, especially in housing and credit markets. Some economists argue that the long period of low volatility encouraged lenders and investors to increase their leverage, contributing to the conditions that eventually triggered the crisis.
Anot6her point of debate centers on the causes of the Great Moderation. While improved monetary policy is often cited as a primary factor, some economists also attribute a significant role to "good luck"—a period with fewer and smaller economic shocks—or to structural changes in the economy, such as shifts from manufacturing to services or improved inventory management practices. The finan5cial crisis and subsequent Great Recession led many to question whether the policies of the Great Moderation had simply postponed deeper economic adjustments, allowing underlying problems to accumulate.
Great Moderation vs. Great Recession
The Great Moderation and the Great Recession represent contrasting periods in modern economic history. The Great Moderation was characterized by exceptionally low macroeconomic volatility, stable inflation, and mild, infrequent recession periods, lasting from the mid-1980s until late 2007. It fostered a belief in the efficacy of modern monetary policy and contributed to an environment of sustained economic growth and low unemployment rate.
In stark4 contrast, the Great Recession, which began in December 2007, marked a severe downturn, characterized by a sharp decline in Gross Domestic Product (GDP), a dramatic increase in the unemployment rate, and significant turbulence in global financial markets. It effect3ively ended the era of the Great Moderation, highlighting the underlying vulnerabilities that had accumulated during the preceding period of calm. While the Great Moderation symbolized stability and predictability, the Great Recession exemplified severe economic disruption and uncertainty.
FAQs
What caused the Great Moderation?
The causes of the Great Moderation are debated among economists, but common explanations include improved monetary policy by central banks (such as the Federal Reserve), structural changes in the economy (like a shift from manufacturing to services and better inventory management), and a period of relatively fewer and smaller economic shocks, sometimes referred to as "good luck."
When2 did the Great Moderation officially end?
Most economists and historians mark the end of the Great Moderation with the onset of the 2007–2009 financial crisis and the subsequent Great Recession. This period of severe economic contraction and increased volatility sharply contrasted with the preceding decades of stability.
Why is1 the Great Moderation considered important?
The Great Moderation is considered important because it represented a significant shift towards greater macroeconomic volatility and price stability compared to earlier periods. This stability had broad implications for economic policy, investment strategies, and public confidence, shaping the economic landscape for over two decades.