The term Great Moderation refers to the sustained period of reduced macroeconomic volatility experienced in the United States starting in the 1980s. During this era, the standard deviation of quarterly real gross domestic product (GDP) decreased by half, while the standard deviation of inflation saw a two-thirds decline. This trend culminated in a multi-decade period characterized by low inflation rates and ongoing economic growth.
Key Highlights
- The Great Moderation began in the mid-1980s, lasting until the onset of the financial crisis in 2007.
- Former U.S. Federal Reserve Chair Ben Bernanke attributed the phenomenon to three main factors in a 2004 speech: structural changes in the economy, improved economic policies, and good luck.
- This period ended abruptly with the Great Recession, marking it as a precursor to one of the most severe global economic downturns since the Great Depression.
The Foundations of the Great Moderation
Prior to the Great Moderation, the U.S. economy experienced wild fluctuations, including significant economic swings and skyrocketing inflation rates. Recurring challenges from the 1960s Vietnam War inflation, the collapse of the Bretton Woods system, the stagflationary periods of the 1970s, and the high interest rate environment of the early 1980s set the stage for a newfound era of stability.
Economic Stability During This Period
The era of the Great Moderation witnessed low and stable inflation and moderate recessions relative to preceding years.
The Federal Reserve’s Role in the Great Moderation
Many credit the reduced volatility during the Great Moderation to the strategic monetary policies enacted under the leadership of Federal Reserve Chairs Paul Volcker, Alan Greenspan, and Ben Bernanke. In his 2004 address, Bernanke discussed several factors contributing to the Great Moderation:
- Structural Changes: These include the embracement of technological advancements allowing for more accurate decision-making, the evolution of the financial sector, deregulation, a pivot toward service-based economics, and increased openness to trade.
- Improved Economic Policies: Economists believe that the adoption of more sophisticated monetary and fiscal policies helped smooth out traditional economic boom-bust cycles.
- Good Luck: Statistical studies suggest that the era’s relatively lower occurrence of economic shocks played a major role in maintaining stability.
In retrospect, Bernanke’s assessment was often criticized as overly optimistic, as it came just before the onset of a major economic crisis.
The Decline: The Great Recession
In the years following Bernanke’s lauding of the Great Moderation, the era’s stability ended abruptly with the financial crisis and subsequent Great Recession. Imbalances built from prolonged loose monetary policies resulted in substantial economic turmoil. By early 2008, issues like the collapse of the U.S. housing market and soaring inflation laid bare severe vulnerabilities, disrupting the flow of credit and liquidity.
Untangling the Economic Unraveling
The entangled effects of globalization, interconnected financial markets, and the U.S. dollar’s dominance obscured inflationary policies that should have driven higher domestic prices. Each modest recession during the Great Moderation saw exacerbated inflationary measures from the Federal Reserve, masking underlying lawfulness within the economy and prolonging inevitable reconciling consequences.
Ultimately, the framework aimed at maintaining long-term stability by deferring periodic minor recessions culminated in the catastrophic economic crash of 2008. The economy treated with band-aid solutions and temporary relief proved unsustainable, leading to widespread financial meltdown upon reaching its breaking point.
Related Terms: real GDP, macroeconomic volatility, monetary policy, Great Recession, macroprudential policies.
References
- The Federal Reserve Board. “Remarks by Governor Ben S. Bernanke”.
