Will Hambly

Economics 361
Professor McIntyre
Business Cycle Dynamics:

The Great Moderation

John Maynard Keynes famously expressed in his 1923 work, A Tract on Monetary

Reform, "…[The] long run is a misleading guide to current affairs. In the long run, we are all

dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can

only tell us that when the storm is long past the ocean is flat again."1 Much of macroeconomics

is dedicated to explaining business cycles. This is not surprising, as times of economic volatility

affect nearly every segment of society. The motivation for much of Keynes’ later work was to

explain one of the most dramatic business cycle fluctuations in recent history, the Great

Depression. Fortunately for the U.S. economy, both innovations in the private sector and in

monetary policymaking have resulted in a dramatic reduction in business cycle volatility.

Since the 1980s, the U.S. macroeconomy has undergone a great transformation. Periods

of dramatic boom and bust, which have characterized economic behavior since the Civil War,

have largely disappeared. Not only has output growth moderated to a more predictable and

comfortable pace, but price behavior has also stabilized. Accompanying this moderation in key

macroeconomic variables has been both a change in the structure of the macroeconomy and

several innovations in policymaking. Over the last quarter century, a technological revolution

has taken place, affecting both business structure and the ways in which firms interact.

Policymakers are also credited with a better understanding of the tools of monetary policy and

their implementation. Recent advancements in information technology have allowed firms and

workers to better adapt to economic conditions, resulting in less pronounced business cycles with

1
John Maynard Keynes. A Tract on Monetary Reform. London: Macmillan and Company, 1923.
 Hambly 2

more consistent growth and full employment. Even traditional economic relationships between

output and inflation have been challenged as the economy has undergone significant changes.

While macroeconomists have sparred over theories explaining the reduction in business cycle

volatility, the impacts of the reduction in output variation are irrefutable and omnipresent. The

reduction in U.S. business cycle volatility since 1980 has been a great boon to households, firms,

and policymakers as the economic environment has become more certain. Reduced volatility

seen in output and prices has several benefits, allowing people to enjoy more consistent

employment and reduce the amount of resources devoted to economic planning and hedging

against inflation. The persistent decline in macroeconomic volatility, known as the “Great

Moderation,” is the result of both structural changes in the economy and better monetary

policymaking. Structural changes include a smoothing of the components of output, the

increased sophistication of financial markets, and innovations in information technology.

Related to macroeconomic policymaking, better monetary policy, specifically an anchoring of

inflation expectations and an understanding of past mistakes, has contributed to the decline in

volatility. Together both structural changes and innovations in policymaking have significantly

changed the U.S. economic landscape. This paper will examine the roles of structural changes in

the economy and monetary policymaking with regard to the recent reduction in business cycle

volatility.

For most of the 20th century, the U.S. macroeconomy performed extremely well, with an

average growth rate of 3.5% per year. This average rate of annual growth, however, masks the

fluctuations around the underlying trend, or natural rate. For much of the 1900s, steady output

growth was punctuated by periods of dramatic contraction and expansion, known as the business

cycle. In the last thirty years, however, these fluctuations in output have been less pronounced,
 Hambly 3

as contractions and expansions beyond the underlying trend have become more short-lived and

less extreme. As documented by macroeconomists Olivier Blanchard and John Simon, the

standard deviation of output has declined markedly since 1950. Evidence of the decline in

business cycle fluctuation is data on the frequency and length of economic expansions.

Blanchard and Simon note that the average length of an expansion during the 1947 to 1981

period was nineteen quarters, compared to an expansion of thirty six quarters for the 1982 to

2000 period.2 Also accompanying the significant reduction in output volatility has been a

moderation in both price variability and the unemployment rate. Essentially, the evidence has

shown that gyrations in the price level have become dampened and unemployment has been

more consistently at its long-run natural rate.

Blanchard and Simon note in their 2001 paper, The Long and Large Decline in U.S.

Output Volatility, that the decline in output variation has largely been a result of the behavior of

government spending, consumption, and investment activity.3 They attribute volatility in the

early period to erratic fiscal policies during both the Korean and Vietnam wars. Fiscal expansion

also affected the volatility of output as spending increased during Johnson’s Great Society

program. With respect to consumption and investment activity, Blanchard and Simon attribute

the lower volatility to increased competition and liquidity in financial markets. Viewed thought

the intertemporal lens, with better access to credit and savings vehicles, firms and consumers

face a more linear budget constraint through their initial endowment point. For the

representative household, with imperfect credit markets the interest rate charged on borrowing

generally exceeds the yield obtainable for savings, resulting in a kinked budget constraint.

Under these conditions, as current income changes, current consumption will increase

2
Olivier Blanchard and John Simon. The Long and Large Decline in U.S. Output Volatility. Massachusetts Institute
of Technology, 2001.
3
Blanchard, 30.
 Hambly 4

proportionally, making consumption more volatile than it would be otherwise with consumption

smoothing. Increased sophistication and competition in financial markets have decreased the

spread between borrowing and lending rates, enabling households and firms to smooth

consumption and investment across periods as income and profits change.4 The result is a

smoothing of the components of output. Blanchard and Simon explain that there has been a

secular decline in output volatility because of the smoothing effect and that recessions may

become less frequent in the future. They warn, however, that there is no “New Economy” as was

touted in the late 1990s, but admit that the economy has indeed changed.

Some critics dismiss the idea that there has been any secular trend in output volatility,

citing the prevalence of adverse supply shocks of the 1970s, when the price of oil reached record

highs. According to critics, simply because of good luck, no significant shocks have affected the

economy since the 1980s, contributing to the decline in output and price volatility during the

recent period.5 Blanchard and Simon respond to this claim by removing from their data the

recessions caused by supply shocks. Their findings confirm that even with the severe recessions

because of oil price shocks in the 1970s, the behavior of output has still exhibited a decline in

volatility.6 Blanchard and Simon reject the random walk hypothesis that the decline in volatility

could merely be the result of good luck.

While Blanchard and Simon offer an analytically robust explanation of the decline in

macroeconomic volatility, their analysis fails to explain it entirely. Specifically, the role of

information technology and its productivity enhancing characteristics within the firm is omitted

from their analysis. While the concept of a “New Economy,” as proclaimed during the

exuberance of the 1990s is debatable, there is little doubt that information technology, including

4
Blanchard, 38.
5
Blanchard, 13.
6
Blanchard, 14.
 Hambly 5

productivity applications, telecommunications, and the rise of the internet, has greatly impacted

productivity. Nobel laureate Robert Solow was ahead of his time when he commented in 1987

that, “We see the computer age everywhere but in the productivity statistics.”7 Between 1973

and 1995 labor productivity grew only at 1.3% per year, compared to 2.5% per year from 1995 to

1999.8 This explosion in productivity growth, not seen since the 1960s, has both challenged the

traditional relationship between economic variables and contributed to a distinct smoothing in

output. Indeed, the effects of the computer age have been seen in the productivity statistics, as

nearly one-third of the growth in labor productivity during the 1990s came from information

technology.9 Advancements in information technology have been seen not only in productivity

and growth statistics, but also in the smoothing of macroeconomic variables as discussed earlier.

Specifically, inventory and supply chain management, along with the increased dissemination of

management technique through information technology, have contributed to a rapid decline in

macroeconomic volatility.

One of the chief explanations for the decline in output volatility is better inventory and

supply chain management techniques employed by firms. The widespread adoption of

information technology by businesses has impacted both how firms plan for the future and the

nature of the production process. Economists Kahn, McConnell, and Perez-Quiros argue in their

2002 paper that inventory behavior has changed significantly since the adoption of new

information technologies. The new inventory and production management techniques allowed

by these technologies has played a direct role in the moderation of output overall.10 They find

that most of the decrease in volatility that began in the early 1980s can be attributed to a
7
Robert Solow, 1987.
8
Kevin Stiroh. What Drives Productivity Growth? Federal Reserve Bank of New York, 2001.
9
Stephen Oliner and Daniel Sichel. The Resurgence of Growth in the Late 1990s: Is Information Technology the
Story? Journal of Economic Perspectives, 2000.
10
James Kahn. On the Causes of the Increased Stability of the U.S. Economy. Federal Reserve Bank of New York,
2002.
 Hambly 6

reduction in the volatility of the durable goods sector. The 50% decline in durable goods

volatility, as measured by the standard deviation, occurred at nearly the same time as aggregate

output variation contracted. They find through econometric modeling techniques that the

volatility reduction in the durables sector was large enough to explain 66% of the reduction in

aggregate output volatility.11 Furthermore, this reduction in volatility does not arise from merely

a reduction in final sales volatility, but from production volatility. Kahn estimates that only 15%

of the decline in output volatility in the durables sector can be attributed to a change in sales

volatility.12 Volatility seen in sales figures provides an obvious justification for a decline in

output volatility, as production is performed to fulfill sales orders. With much of the volatility,

however, coming from production, the role of inventory management becomes apparent.

Over the last quarter century, both target inventory to sales ratios and deviations from

target inventory levels have significantly declined. As calculated by the U.S. Department of

Commerce, the inventory to sales ratio for the U.S. economy declined by nearly 16% during the

1992 to 2007 period.13 In his 2002 paper, Kahn decomposes the inventory to sales ratio into

trend and transitory components. The trend component is the target inventory to sales ratio,

which is driven by the advancement of information technologies. The transitory component,

however, is the deviation in the inventory to sales ratio from the desired trend component. He

shows that the target inventory to sales ratio has declined markedly the early 1980s. In addition

to the decline in the target inventory to sales target ratio, deviations of the transitory component

around the target have dampened significantly.14 As the desired amount of inventory held by

firms relative to sales has fallen, businesses have also become more adept at managing the

inventory they hold and targeting their desired levels. The reduction in the target inventory to
11
Kahn, 185.
12
Kahn, 186.
13
U.S. Department of Commerce, Inventory to Sales Ratio, Federal Reserve Economic Data.
14
Kahn, 187.
 Hambly 7

sales ratio shows the impact of information technology, specifically powerful computers,

productivity applications, and telecommunications. These innovations have revolutionized how

firms relate to inventory and manage their supply chains. The result of these innovations has

been a reduction in the level of production volatility.

To better understand the exact role inventory and supply chain management play in

affecting output volatility and the impact of information technologies, I have created a model

based on Kahn’s presentation in On the Causes of the Increased Stability of the U.S. Economy.

In my model of inventory and production decisions, there are three firms, the Low Information

Firm, the High Information Firm, and the Very High Information Firm. Each firm faces the same

final sales for each period, which are determined by a random number generator and lie between

50 and 150.15 Each firm also must make a production decision each period, and is unable to alter

its decision after it has dedicated itself to a specific amount. This production decision is based

on what each firm believes will be sales next period but also incorporates an inventory

accumulation or exhaustion component. Additionally, all three firms have a target inventory to

sales ratio which is determined exogenously. With respect to production, the Low Information

Firm bases its production decision solely on last period’s sales, which is based upon the

underlying assumption that next period’s sales are equal to this period’s sales plus a random error

term. The fact that the low information firm bases production on last period’s sales is intuitive

assuming the stochastic behavior of sales for each period. The other two firms, the High

Information Firm and the Very High Information Firm are more advanced in their understanding

of next period’s sales. They base their production decisions with perfect information of the next

period’s final sales. That means they are able to produce exactly enough to meet sales, but must

15
The first four final sales figures are were determined by myself for ease of calculation and understanding the
model.
 Hambly 8

alter production if they deviate from their target inventory level given their inventory to sales

ratios. Inventory to sales ratios for both the Low Information Firm and the High Information

Firm are fixed at a level of two, while the Very High Information Firm has a declining inventory

to sales ratio to represent the adoption of inventory eliminating information technologies and

better supply chain management. Throughout the model, production is used to both fill sales

projections and to attain the desired inventory to sales ratio. Inventories are used to fulfill sales

in the event of a shortfall in production for the Low Information Firm and can be interpreted as a

security buffer in the case of misjudgments in sales projections by both the High and Very High

Information Firms. Data for each of the firms is can be seen in Figures 1, 2, and 3. The results

of a 20 period simulation reveal exactly how new technologies can smooth production and offer

striking implications for the role of inventories and new technologies.

The results of the simulation show the standard deviations of production for the Low,

High, and Very High firms at 176.13, 94.57, and 36.05 respectively. For the Very High

Information firm, the volatility of production declined by a staggering 80% relative to the Low

Information Firm. After the adoption of information technology, production volatility fell as

theorized. The new technology impacted the firm in two distinct ways. Contrasting the Low

Information Firm with the High Information Firm, the only change was that the firm equipped

with high information was able to accurately predict future sales, mitigating the need to draw

down on inventories in the event of a large spike in sales. Instead the volatility in production

came from maintaining desired inventory to sales ratios. While the idea that firms can accurately

predict future sales in the next period is a bit extreme, it is not far from reality given econometric

modeling techniques coupled with integrated barcode systems and the emerging radio frequency

identification (RFID) technology found at the retail and manufacturing level. With the wide
 Hambly 9

availability of accurate data, manufacturers are able to see sales and production needs in real-

time, enabling more accurate forecasts of future sales.16 Besides the benefit of knowing exactly

what future sales would be, the Very High Information firm had a declining inventory to sales

ratio, reflecting innovation in supply chain management and the use of just-in-time production.

Using information technologies, the representative firm is able to reduce the need to hold costly

inventories, which not only take up physical space but occupy labor in unproductive activities.

As telecommunications technologies have improved, coordinating inputs from various suppliers

for production has become easier, eliminating the need for inventories and speeding up the

production process. As inventories are eliminated, the inventory to sales ratio obviously falls,

reducing the need to vary production widely in an effort to obtain target inventory levels.

In addition to the inventory channel, advancements in information technology have

affected the smoothing of output through the production function. Specifically, shocks to the

total factor productivity have decreased. Consider a simple model of the production process, Y =

ZLαK1-α, where Y is real output, Z is a measure of total factor productivity, and L and K are labor

and capital respectively. Economists Stephen Oliner and Daniel Sichel note that during the 1974

to 1999 period, total factor productivity growth made up more than one-third of the growth in

labor productivity.17 Besides the productivity enhancing characteristics of new technologies,

they have likely influenced a moderation in output volatility. As new information technologies,

specifically productivity applications, data management software, and telecommunications

devices, have become more widespread, shocks to total factor productivity, the variable Z, have

become smaller. With better data and communications devices, management techniques and the
16
Erik Brynjolfsson and Lorin Hitt discuss the impacts of computers and productivity applications at great length
and specificity in their 2000 paper Beyond Computation: Information Technology, Organizational Transformation,
and Business Performance, Journal of Economic Perspectives. Their granular, but highly enlightening, analysis,
however, is beyond the scope of this paper.
17
Stephen Oliner and Daniel Sichel. The Resurgence of Growth in the Late 1990s: Is Information Technology the
Story? Journal of Economic Perspectives, 2000.
 Hambly 10

best practices within firms have become more consistent and widely shared throughout

individual companies and industries. Interactions between capital and labor have not only

become more efficient, but have become more reliably efficient as management technique and

know-how abounds in the modern information-laden firm. Total factor productivity has also

been affected by the decline in inventories relative to sales. With fewer inventories to manage,

labor and capital resources are not distracted from productive activities to manage inventories.

With the inventory shock to total factor productivity lessened or eliminated, output is able to

grow at a smoother rate with less period interruption.

Besides the impact of structural factors which have contributed to the decline in

macroeconomic volatility, much research has focused on how monetary policymaking has

impacted the recent stability of macroeconomic variables. In contrast to the Great Inflation

period of the 1970s, the subsequent Volcker-Greenspan era has been characterized by a marked

stabilization in both inflation and output. During much of the 1970s, the U.S. economy was

characterized by high inflation and deep recessions. The blame for the increase in inflation

during this period falls squarely on the shoulders of an accommodative central bank. The

Volcker-Greenspan era of policymaking, however, has brought about a distinct smoothing of

output and prices through an enhanced understanding of inflation expectations, an

implementation of the Taylor principle, and a flattening of the Phillips curve.

The recent decline in price volatility relative to the pre-Volcker era can be characterized

as a decrease in both inflation persistence and an anchoring of inflation expectations. Frederic

Mishkin, member of the Board of Governors of the Federal Reserve, notes that since the early

1970s, the persistence of inflation has declined markedly.18 Given an inflationary shock,

inflation reverts more quickly to its long-run level than it has in the past. By regressing inflation
18
Frederic Mishkin. Remarks by Governor Frederic S. Mishkin: Inflation Dynamics. Federal Reserve, 2007.
 Hambly 11

on twelve lags of itself, Mishkin notes that the coefficients sum to approximately 0.6 and has

declined significantly since the 1970s.19 A decline in the sum of lagged coefficients signifies that

the impact of inflation only produces a small amount of additional pressure in the future, a boon

to policymakers. James Stock and Mark Watson explain a similar phenomenon in their 2007

paper with regard to inflation persistence. They decompose inflation into trend and transitory

components and note that trend inflation has decreased significantly while the transitory

component has become less important in determining inflation.20 The anchoring of trend

inflation signifies a reduction in inflation expectations. This decline in inflation expectations and

actual inflation are mutually reinforcing. As expectations remain anchored, actual inflation

remains low, fulfilling the low expectations and offering additional credibility to the central

bank. Credibility is important because even if inflation rises temporarily, long-run expectations

will remain anchored and not impact trend inflation. While the decline in the variability of prices

has been less pronounced than the moderation of output, it is a significant change to the

macroeconomic environment that can be attributed to better monetary policymaking and the

stability of inflation expectations.

In addition to the taming of inflation expectations, better monetary policy has affected the

variability of inflation through an adherence to the Taylor principle. While the principles of

sound money were certainly well known during much of the 20th century, data shows that only

over the last 30 years have monetary policymakers demonstrated a competence in reducing

inflation and its volatility. Specifically, under the chairmanship of Paul Volcker, the Federal

Reserve began to tame inflation with an adherence to the Taylor principle. Upon arriving at the

Federal Reserve, Chairman Volcker faced double-digit rates of inflation, but his hawkish stance

19
Mishkin.
20
James Stock and Mark Watson. Why Has U.S. Inflation Become Harder to Forecast? Journal of Money, Credit
and Banking, 2007.
 Hambly 12

and use of the Taylor principle quickly reduced both actual inflation and inflation expectations.

The Taylor principle is the idea that given an increase in the rate of inflation, the nominal Fed

Funds rate must increase by more than the rate of inflation for the interest rate increase to have

real effects. This simple principle, while well know during the Great Inflation, was not adhered

to by the Federal Reserve. Economist Richard Clarida explains that the Fed’s priorities have

changed significantly since the 1970s. In his 2000 study of the behavior of the Federal Reserve,

he finds that the Fed’s response to inflationary pressure changed dramatically from the pre-

Volcker period to the Volcker-Greenspan period. Using John Taylor’s specification of the

famous Taylor Rule, Clarida constructs a model of the nominal Fed Funds rate using the

equilibrium real rate of interest, the deviation of inflation from the implicit target rate, and a

measure of the output gap. Clarida finds that the coefficient on the inflation term increased

noticeably across the pre-Volcker and Volcker-Greenspan periods. Clarida shows that the

coefficient increased from 0.83 to 2.15, both statistically significant.21 Additionally, for the

output gap term, Clarida shows that the coefficient changed from 0.27 to 0.93, with the Volcker-

Greenspan coefficient only marginally significant.22 The increase in the Fed’s responsiveness

shows their adherence to the Taylor principle, as increases in inflation are met with increases in

the real Fed Funds rate. Since the Great Inflation, the Fed has become significantly more

hawkish on inflation, contributing both reduced inflation expectations and lower inflation

overall.

Also contributing to the moderation in inflationary volatility has been a changing

relationship between inflation and output. This relationship is typically expressed through the

Phillips curve, which relates inflation and unemployment. The Phillips curve can be expressed

21
Richard Clarida. Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory. Quarterly
Journal of Economics, 2000.
22
Clarida, 157.
 Hambly 13

as, π = πe – β(U-Un) + ν, in which π represents the rate of inflation, πe is expected inflation, (U-

Un) is the deviation of unemployment from its natural rate, β is the responsiveness of inflation to

capacity utilization, and ν is a supply shock. Recent evidence has shown that the coefficient on

the unemployment term has declined since the 1980s.23 The finding that inflation is less

responsive to changes in capacity utilization has two striking macroeconomic implications. First,

if the coefficient on the unemployment gap has declined, that means the Phillips curve has

flattened, suggesting that changes in resource utilization do not have such a great impact on

inflation. The Fed’s hawkish stance on inflation has likely influenced a flattening of the Phillips

curve, as price increases have become less frequent and the Fed’s ability to manage demand

shocks has been more credible. The result is that people expect inflation to remain contained and

deviations in resource utilization do not cause large changes in inflation. As discussed at great

length before, output has moderated significantly since the 1980s, but there are still fluctuations

in the business cycle. The flattening in the Phillips curve explains also why inflation has

moderated over the same time period as output. Not only has the variability of output decreased,

which would suggest that inflation should have moderated, but inflation’s response to the

business cycle has also dampened. Secondly, the decline in inflation expectations has reduced

the πe term, shifting the Phillips curve closer to the origin and offering policymakers a better

tradeoff. The fact that inflation expectations can shift a flatter Phillips curve also indicates a

potential danger to policymakers and the economy given a flatter Phillips curve. If inflation

expectations were to increase suddenly, policymakers would be forced to sacrifice a larger

amount of output to bring price pressures back to an acceptable level.

Bringing together the two chief macroeconomic variables, output and inflation, is the

Taylor curve, which represents the volatility tradeoff between the two variables. The downward
23
Mishkin.
 Hambly 14

sloping Taylor curve shows the different combinations of output and inflation volatility available

to policymakers. Given an exogenous supply shock, the Taylor curve is a convenient way of

describing the optimal choices policymakers face, as they must choose between keeping prices

stable or output at its natural rate. Recent volatility in both prices and output can be explained by

an inward shift of the Taylor curve. In his 2004 speech, Ben Bernanke explains, “If monetary

policies during the late 1960s and the 1970s were sufficiently far from optimal, the result could

be a combination of output volatility and inflation volatility lying well above the efficient

frontier defined by the Taylor curve.”24 For example, during the 1970s, policymakers had an

overly optimistic view of the economy’s potential, and sought to exploit a long-run version of the

Phillips curve to attain higher output. The result was elevated prices and volatile output as

money growth expanded and output reached a supposed non-inflationary rate that was indeed

inflationary as potential was unclear. With a better understanding of inflation expectations,

implementing the Taylor principle, and a better measure of potential output, policymakers have

contributed to the decline in output and price volatility.

The recent decline in macroeconomic variability, known as the Great Moderation, has its

roots in both structural changes and innovations in monetary policymaking. The components of

output have moderated significantly through the development of deeper financial markets,

technology, and inventory management. On the monetary side, the anchoring of inflation

expectations coupled with better policymaking has reduced the volatility of output and kept

inflation consistently low and stable. The result of the decrease in macroeconomic volatility has

been a great boon for society. The moderation in macroeconomic variables has not only affected

an understanding of macroeconomics, but has improved utility for consumers and businesses

alike. More consistent incomes, sales, employment, and prices have lessened the need for
24
Ben Bernanke, The Great Moderation, 2004.
 Hambly 15

economic planning and the amount of resources devoted to hedging fluctuations in the business

cycle and the impacts of inflation. As technological progress increases and monetary

policymakers further their understanding of the economy, the reduction in macroeconomic

volatility will likely continue.

Bibliography

Ben Bernanke, The Great Moderation, 2004.

Olivier Blanchard and John Simon. The Long and Large Decline in U.S. Output Volatility.
Massachusetts Institute of Technology, 2001.

John Maynard Keynes. A Tract on Monetary Reform. London: Macmillan and Company, 1923.
 Hambly 16

Frederic Mishkin. Remarks by Governor Frederic S. Mishkin: Inflation Dynamics. Federal

Reserve, 2007.

James Kahn. On the Causes of the Increased Stability of the U.S. Economy. Federal Reserve
Bank of New York, 2002.

James Stock and Mark Watson. Why Has U.S. Inflation Become Harder to Forecast? Journal of
Money, Credit and Banking, 2007.

Kevin Stiroh. What Drives Productivity Growth? Federal Reserve Bank of New York, 2001.

Richard Clarida. Monetary Policy Rules and Macroeconomic Stability: Evidence and Some
Theory. Quarterly Journal of Economics, 2000.

Stephen Oliner and Daniel Sichel. The Resurgence of Growth in the Late 1990s: Is Information
Technology the Story? Journal of Economic Perspectives, 2000.

U.S. Department of Commerce, Inventory to Sales Ratio, Federal Reserve Economic Data.

Figures

Figure 1
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Hambly
17