Analyzing Five Decades of U.S. Monetary Policy

Positive and stable investment-specific technological shocks, lowered demand pressures, and labor supply shocks that pressured wages and marginal costs downward together explain most of the Great Moderation.

In (NBER Working Paper No. 15929) Reading the Recent Monetary History of the U.S., 1959-2007, co-authors Jesús Fernández-Villaverde, Pablo Guerrón-Quintana, and Juan Rubio-Ramírez develop a model the U.S. economy and use it to analyze the history of the great American inflation, from the late 1960s to the early 1980s, and of the great moderation of business cycle fluctuations between 1984 and 2007. They divide the nearly fifty-year period into five sub-periods corresponding to different chairs of the Federal Reserve Board of Governors (Martin, Burns-Miller, Volcker, Greenspan, and Bernanke). The researchers find both changes in the volatility of the structural shocks that hit the economy and changes in monetary policy over these decades.

Their analysis suggests that a decline in the volatility of economic shocks accounted for most of the great moderation, while changes in monetary policy accounted for the increase and then the taming of the great American inflation. Results from their model indicate that Inflation remained low during the great moderation in large part because of favorable economic shocks.

The authors estimate that if monetary policy had behaved under Burns and Miller in the 1970s as it did later under Volcker, then inflation would have averaged 4.4 percent per year, rather than 6.2 percent for that decade. In another counterfactual simulation, the authors ask what would have happened if the average monetary policy stance of the Greenspan years had been adopted at the time of Burns's appointment. They conclude that it would not have made much of a difference: inflation would have been slightly higher, 6.8 percent instead of 6.2 percent, in the 1970s. The authors conclude that monetary policy during the Greenspan years was not too different from monetary policy in the Burns-Miller era, but that it was accompanied by more positive economic shocks.

In the Volcker years the response of monetary policy to inflation was consistently strong, but Volcker was an unlucky chairman: the economy suffered from large and negative shocks during his tenure. In a counterfactual simulation in which the direction of the economic shocks during the Volcker period remains fixed, but the magnitude of the shocks is scaled back to match the average volatility over the whole five-decade sample, the price level would begin to fall by the end of 1983, rather than rising at roughly 3 percent per year as it did.

In contrast, economic shocks supported the monetary policy choices of the1990s. Positive and stable investment-specific technological shocks, lower demand pressures, and labor supply shocks that pressured wages and marginal costs downward explain most of the great moderation. Without changes in the volatility of these shocks, the reduction in the variability of inflation would have been only one-fifth of what was observed.

-- Claire Brunel