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46-531: The Great Moderation is typically attributed to the adoption of standards for macroeconomic targeting such as the Taylor rule and inflation targeting . However, some economists argue technological shifts also played a role. The term was coined in 2002 by James Stock and Mark Watson to describe the observed reduction in business cycle volatility. There is some debate as to whether the Great Moderation ended with

92-524: A π > 0 {\displaystyle a_{\pi }>0} , the Taylor rule says that an increase in inflation by one percentage point should prompt the central bank to raise the nominal interest rate by more than one percentage point (specifically, by 1 + a π {\displaystyle 1+a_{\pi }} , the sum of the two coefficients on π t {\displaystyle \pi _{t}} in

138-492: A y {\displaystyle a_{y}} should be positive (as a rough rule of thumb, Taylor's 1993 paper proposed setting a π = a y = 0.5 {\displaystyle a_{\pi }=a_{y}=0.5} ). That is, the rule produces a relatively high real interest rate (a "tight" monetary policy) when inflation is above its target or when output is above its full-employment level, in order to reduce inflationary pressure. It recommends

184-502: A y = 0 {\displaystyle a_{y}=0} .) Other economists proposed adding terms to the Taylor rule to take into account financial conditions: for example, the interest rate might be raised when stock prices, housing prices, or interest rate spreads increase. Taylor offered a modified rule in 1999: that specified a π = 0.5 , a y ≥ 0 {\displaystyle a_{\pi }=0.5,a_{y}\geq 0} . The solvency rule

230-503: A change in the labor market, there were behavioral changes in how corporations managed their inventories. With improved sales forecasting and inventory management, inventory costs became much less volatile, increasing corporation stability. Advances in information technology and communications increased corporation efficiency. The improvement in technology changed the entire way corporations managed their resources as information became much more readily available to them with inventions such as

276-405: A decoupled world because domestic activity was thought to be so robust. On the other hand, after the slump the emerging countries experienced a strong recovery, much stronger than that in advanced economies. The phenomenon of decoupling and re-coupling has been explained by observing that global demand for factors such as capital and raw material declines when one part of the world economy suffers

322-422: A fairly accurate explanation of US monetary policy under Paul Volcker and Alan Greenspan and other developed economies. This observation has been cited by Clarida , Galí , and Gertler as a reason why inflation had remained under control and the economy had been relatively stable in most developed countries from the 1980s through the 2000s. However, according to Taylor, the rule was not followed in part of

368-388: A relatively low real interest rate ("easy" monetary policy) in the opposite situation, to stimulate output. Sometimes monetary policy goals may conflict, as in the case of stagflation, when inflation is above its target with a substantial output gap. In such a situation, a Taylor rule specifies the relative weights given to reducing inflation versus increasing output. By specifying

414-471: A temporary period with a high level of volatility in a longer period where low volatility is the norm, and not as a definitive end to the Great Moderation. However, the decade following Great Recession had some key differences with the economy of the Great Moderation. The economy had a much larger debt overhead. This led to a much slower economic recovery, the slowest since the Great Depression . Despite

460-403: Is increasing the real interest rate) has been called the Taylor principle. The Taylor principle presumes a unique bounded equilibrium for inflation. If the Taylor principle is violated, then the inflation path may be unstable. The concept of a policy rule emerged as part of the discussion on whether monetary policy should be based on intuition/discretion. The discourse began at the beginning of

506-484: Is now commonly assumed that the 2007–2008 financial crisis and the Great Recession brought the Great Moderation period to an end, as was initially argued by some economists such as John Quiggin . Richard Clarida at PIMCO considered the Great Moderation period to have been roughly between 1987 and 2007, and characterized it as having "predictable policy, low inflation, and modest business cycles". However, before

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552-495: Is that a central bank gains the discretion to apply multiple means to achieve the set target. The monetary policy of the Federal Reserve changed throughout the 20th century. The period between the 1960s and the 1970s is evaluated by Taylor and others as a period of poor monetary policy; the later years typically characterized as stagflation . The inflation rate was high and increasing, while interest rates were kept low. Since

598-461: Is the output gap . The ln ⁡ ( 1 + x ) = x {\displaystyle \ln(1+x)=x} approximation is used here. Because of i t − π t = real policy interest rate {\displaystyle i_{t}-\pi _{t}={\mbox{real policy interest rate}}} , In this equation, both a π {\displaystyle a_{\pi }} and

644-473: Is the assumed natural/equilibrium interest rate, y t {\displaystyle \,y_{t}\,} is the natural logarithm of actual GDP , and y ¯ t {\displaystyle {\bar {y}}_{t}} is the natural logarithm of potential output , as determined by a linear trend. y t − y ¯ t {\displaystyle y_{t}-{\bar {y}}_{t}}

690-592: Is typified by the decoupling hypothesis that, in 2007, held that Latin American and Asian economies, especially emerging ones, had broadened and deepened to the point that they no longer depended on the United States economy for growth, leaving them insulated from a slowdown there, even a fully fledged recession . Faith in the concept had generated strong outperformance for stocks outside the United States. However, over

736-513: The 2007–2008 financial crisis and the Great Recession , or if it continued beyond this date, with the crisis being an anomaly. The term "Great Moderation" was coined by James Stock and Mark Watson in their 2002 paper, "Has the Business Cycle Changed and Why?" It was brought to the attention of the wider public by Ben Bernanke (then member and later chairman of the Board of Governors of

782-666: The Bretton Woods agreement collapsed, policymakers focused on keeping interest rates low, which yielded the Great Inflation of 1970. Since the mid-1970s money supply targets have been used in many countries to address inflation targets. Many advanced economies, such as the US and the UK, made their policy rates broadly consistent with the Taylor rule in the period of the Great Moderation between

828-564: The federal funds rate in the US, the Bank of England base rate in the UK), π t {\displaystyle \,\pi _{t}\,} is the rate of inflation as measured by the GDP deflator , π t ∗ {\displaystyle \pi _{t}^{*}} is the desired rate of inflation, r t ∗ {\displaystyle r_{t}^{*}}

874-400: The federal funds rate , the price level and changes in real income . The Taylor rule computes the optimal federal funds rate based on the gap between the desired (targeted) inflation rate and the actual inflation rate; and the output gap between the actual and natural output level. According to Taylor, monetary policy is stabilizing when the nominal interest rate is higher/lower than

920-463: The "good luck" explanation, and attribute it mainly to monetary policies. There were many large economic crises — such as the Latin American debt crisis , the failure of Continental Illinois in 1984, Black Monday (1987) , the 1997 Asian financial crisis , the collapse of Long-Term Capital Management in 1998, and the dot-com bubble in 2000 — that did not greatly destabilize the US economy during

966-558: The 19th century. The first formal debate forum was launched in the 1920s by the US House Committee on Banking and Currency. In the hearing on the so-called Strong bill, introduced in 1923 by Representative James G. Strong of Kansas, the conflict in the views on monetary policy clearly appeared. New York Fed Governor Benjamin Strong Jr. (no relation to Representative Strong), supported by Professors John R. Commons and Irving Fisher ,

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1012-438: The 2000s began the actual interest rate in advanced economies, especially in the US, was below that suggested by the Taylor rule. The deviation can be explained by the fact that central banks were supposed to mitigate the outcomes of financial busts, while intervening only given inflation expectations. Economic shocks were accompanied by lower rates. While the Taylor principle has proven influential, debate remains about what else

1058-456: The 2000s the actual interest rate in advanced economies , especially in the US, was below that suggested by the Taylor rule. A change in economic structure shifted away from manufacturing, an industry considered less predictable and more volatile. The Sources of the Great Moderation by Bruno Coric supports the claim of drastic labor market changes, noting a high "increase in temporary workers, part time workers and overtime hours". In addition to

1104-566: The 2000s, possibly inflating the housing bubble. Some research has reported that households form expectations about the future path of interest rates, inflation, and unemployment in a way that is consistent with Taylor-type rules. The Taylor rule is debated in the discourse of the rules vs. discretion. Limitations of the Taylor rule include. Taylor highlighted that the rule should not be followed blindly: "…There will be episodes where monetary policy will need to be adjusted to deal with special factors." Athanasios Orphanides (2003) claimed that

1150-521: The Covid-19 pandemic, the US real GDP growth rate, the real retail sales growth rate, and the inflation rate had all returned to roughly what they were before the Great Recession. Todd Clark has presented an empirical analysis which claims that volatility, in general, has returned to the same level as before the Great Recession . He concluded that while severe, the 2007 recession will in future be viewed as

1196-727: The Federal Reserve ) in a speech at the 2004 meetings of the Eastern Economic Association. Since the Treasury–Fed Accord of 1951 , the US Federal Reserve was freed from government and gave way to the development of modern monetary policy. According to John B. Taylor, this allowed the Federal Reserve to abandon discretionary macroeconomic policy by the US Federal government to set new goals that would better benefit

1242-484: The Great Moderation. Stock and Watson used a four variable vector autoregression model to analyze output volatility and concluded that stability increased due to economic good luck. Stock and Watson believed that it was pure luck that the economy didn't react violently to the economic shocks during the Great Moderation. While there were numerous economic shocks, there is very little evidence that these shocks are as large as prior economic shocks. Research has indicated that

1288-404: The Taylor rule can mislead policy makers who face real-time data . He claimed that the Taylor rule matches the US funds rate less perfectly when accounting for informational limitations and that an activist policy following the Taylor rule would have resulted in inferior macroeconomic performance during the 1970s. In 2015, "Bond King" Bill Gross said the Taylor rule "must now be discarded into

1334-458: The US monetary policy that contributed to the drop in the volatility of US output fluctuations also contributed to the decoupling of the business cycle from household investments characterized the Great Moderation. The latter became the toxic assets that caused the Great Recession . According to Hyman Minsky the great moderation enabled a classic period of financial instability, with stable growth encouraging greater financial risk taking. It

1380-542: The barcode. Information technology introduced the adoption of the "just-in-time" inventory practices. Demand and inventory became easier to track with advancements in technology, corporations were able to reduce stocks of inventory and their carrying costs more immediately, both of which resulted in much less output volatility. Researchers at the US Federal Reserve and the European Central Bank have rejected

1426-419: The concept of targeting the forecast, such that policy is set to achieve the goal rather than merely to lean in one direction or the other. One proposed mechanism for assessing the impact of policy was to establish an NGDP futures market and use it to draw upon the insights of that market to direct policy. Although the Federal Reserve does not follow the Taylor rule, many analysts have argued that it provides

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1472-436: The course of 2008, as fears of recession mounted in the United States, worldwide stock markets declined heavily. Contrary to the decoupling hypothesis, the losses were greater outside the United States, with the worst experienced in emerging markets and developed economies like Germany and Japan . Exports make up especially large portions of economic activity in those places, but that fact was not supposed to matter anymore in

1518-466: The economy. The Taylor rule results in less policy instability, which should reduce macroeconomic volatility. The rule prescribed setting the bank rate based on three main indicators: the federal funds rate , the price level and the changes in real income . The Taylor rule also prescribes economic activity regulation by choosing the federal funds rate based on the inflation gap between desired (targeted) inflation rate and actual inflation rate; and

1564-533: The end of the 20th-century. It targets the nominal gross domestic product . He proposed that the Fed stabilize nominal GDP. The McCallum rule uses precise financial data. Thus, it can overcome the problem of unobservable variables. Market monetarism extended the idea of NGDP targeting to include level targeting. (targeting a specific amount of growth per time period, and accelerating/decelerating growth to compensate for prior periods of weakness/strength). It also introduced

1610-425: The equation). Since the real interest rate is (approximately) the nominal interest rate minus inflation, stipulating a π > 0 {\displaystyle a_{\pi }>0} implies that when inflation rises, the real interest rate should be increased. The idea that the nominal interest rate should be raised "more than one-for-one" to cool the economy when inflation increases (that

1656-490: The increase/decrease in inflation . Thus the Taylor rule prescribes a relatively high interest rate when actual inflation is higher than the inflation target. In the United States , the Federal Open Market Committee controls monetary policy. The committee attempts to achieve an average inflation rate of 2% (with an equal likelihood of higher or lower inflation). The main advantage of a general targeting rule

1702-432: The limited number of factors it considers. According to Taylor's original version of the rule, the real policy interest rate should respond to divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product (GDP) from potential GDP: In this equation, i t {\displaystyle \,i_{t}\,} is the target short-term nominal policy interest rate (e.g.

1748-539: The low volatility of the economy, few would argue that the 2009-2020 economic expansion, which was the longest on record, was carried out under Goldilocks economic conditions. Andrea Riquier dubs the post-Great Recession period as the "Great Stability". Taylor rule The Taylor rule is a monetary policy targeting rule. The rule was proposed in 1992 by American economist John B. Taylor for central banks to use to stabilize economic activity by appropriately setting short-term interest rates . The rule considers

1794-438: The mid-1970s monetary targets have been used in many countries as a means to target inflation. However, in the 2000s the actual interest rate in advanced economies , notably in the US, was kept below the value suggested by the Taylor rule. The Taylor rule is typically contrasted with discretionary monetary policy, which relies on the personal views of the monetary policy authorities. The Taylor rule often faces criticism due to

1840-438: The mid-1980s and early 2000s. That period was characterized by limited inflation/stable prices. New Zealand went first, adopting an inflation target in 1990. The Reserve Bank of New Zealand was reformed to prioritize price stability, gaining more independence at the same time. The Bank of Canada (1991) and by 1994 the banks of Sweden, Finland, Australia, Spain, Israel and Chile were given the mandate to target inflation. Since

1886-485: The output gap between the actual and natural level. In an American Economic Review paper, Troy Davig and Eric Leeper stated that the Taylor principle is countercyclical in nature and a "very simple rule [that] does a good job of describing Federal Reserve interest-rate decisions". They argued that it is designed for "keeping the economy on an even keel", and that following the Taylor principle can produce business cycle stabilization and crisis stabilization. However, since

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1932-443: The rule should incorporate. According to some New Keynesian macroeconomic models, insofar as the central bank keeps inflation stable, the degree of fluctuation in output will be optimized (economists Olivier Blanchard and Jordi Gali call this property the ' divine coincidence '). In this case, the central bank does not need to take fluctuations in the output gap into account when setting interest rates (that is, it may optimally set

1978-400: The trash bin of history", in light of tepid GDP growth in the years after 2009. Gross believed that low interest rates were not the cure for decreased growth, but the source of the problem. Decoupling and re-coupling In economics , decoupling and re-coupling is where countries are no longer economically impacted by the economies of other countries and visa versa. A financial crises

2024-444: Was almost wholly preventable and that it would have been prevented if Governor Strong had lived, who was conducting open-market operations with a view of bringing about stability". Later on, monetarists such as Milton Friedman and Anna Schwartz agreed that high inflation could be avoided if the Fed managed the quantity of money more consistently. The 1960s recession in the US was accompanied by relatively high interest rates. After

2070-479: Was concerned about the Fed's practices that attempted to ensure price stability. In his opinion, Federal Reserve policy regarding the price level could not guarantee long-term stability. After the death of Governor Strong in 1928, political debate on changing the Fed's policy was suspended. The Fed had been dominated by Strong and his New York Reserve Bank . After the Great Depression hit the country, policies came under debate. Irving Fisher opined, "this depression

2116-423: Was presented by Emiliano Brancaccio after the 2008 financial crisis. The banker follows a rule aimed to control the economy's solvency . The inflation target and output gap are neglected, while the interest rate is conditional upon the solvency of workers and firms. The solvency rule was presented more as a benchmark than a mechanistic formula. The McCallum rule :was offered by economist Bennett T. McCallum at

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