We offer a tale of two major postwar business cycle episodes: the pre-1980s and the post-1982s prior to the Great Recession. We revisit the sources of business cycles and the reasons for the large variations in aggregate volatility from the first to the second episode. Using a medium-scale DSGE model where monetary policy potentially has cost-channel effects, we first show the Fed most likely targeted deviations of output growth from trend growth, not the output gap, for measure of economic activity. When estimating our model with a policy rule reacting to output growth with Bayesian techniques, we find the US economy was not in a state of indeterminacy in either of the two subperiods. Thus, aggregate instability before 1980 did not result from self-fulfilling changes in inflation expectations. Our evidence shows the Fed reacted more strongly to inflation after 1982. Based on sub-period estimates, we find that shocks to the marginal efficiency of investment largely drove the cyclical variance of output growth prior to 1980 (61%), while they have seen their importance falls dramatically after 1982 (19%). When looking at the sources of greater macroeconomic stability during the second episode, we find no support for the “good-luck hypothesis”. Change in nominal wage flexibility largely drove the decline in output growth volatility, while the change in monetary policy was a key factor lowering inflation variability.

Additional Metadata
Keywords Conventional Monetary Policy, Determinacy, Bayesian Estimation, Sources of Business, Cycle, Changes in Aggregate Volatility.
JEL Price Level; Inflation; Deflation (jel E31), Business Fluctuations; Cycles (jel E32), Forecasting and Simulation (jel E37)
Publisher Carleton University
Series Carleton Economics Working Papers (CEWP)
Citation
Khan, H.U, Phaneuf, Louis, & Victor, Jean-Gardy. (2020). A Tale of Two Major Postwar Business Cycle Episodes. Carleton Economics Working Papers (CEWP). Carleton University.