The Great Recession of 2007-09 was a dramatic macroeconomic event, marked by a severe contraction in economic activity and a significant fall in inflation. These developments surprised many economists, as documented in a recent post on this site. One factor cited for the failure to anticipate the magnitude of the Great Recession was a form of complacency affecting forecasters in the wake of the so-called Great Moderation. In this post, we attempt to quantify the role the Great Moderation played in making the Great Recession appear nearly impossible in the eyes of macroeconomists.
In the twenty years that preceded the Great Recession, the U.S. economy had displayed remarkable stability—a phenomenon that James Stock of Harvard and Mark Watson of Princeton dubbed “the Great Moderation.” Most economists attributed this relatively sudden reduction in the volatility of macroeconomic variables, starting around 1984, to a combination of “good luck”—in the form of less severe external shocks hitting the economy—and “good policy,” especially in the form of greater Fed vigilance on inflation, as well as to other forms of structural change.
The Great Moderation, Forecast Uncertainty, and the Great Recession
ReplyDeleteby Ging Cee Ng and Andrea Tambalotti
http://libertystreeteconomics.newyorkfed.org/2012/05/the-great-moderation-forecast-uncertainty-and-the-great-recession.html
… In sum, our calculations suggest that the Great Recession was indeed entirely off the radar of a standard macroeconomic model estimated with data drawn exclusively from the Great Moderation. By contrast, the extreme events of 2008-09 are seen as far from impossible—if unlikely—by the same model when the shocks hitting the economy are gauged using data from a longer period (third-quarter 1954 to fourth-quarter 2007). These results provide a simple quantitative illustration of the extent to which the Great Moderation, and more specifically the assumption that the tranquil environment characterizing it was permanent, might have led economists to greatly underestimate the possibility of a Great Recession.
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