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The Great Diversification and Its Undoing

Author

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  • Vasco Carvalho
  • Xavier Gabaix

Abstract

We investigate the hypothesis that macroeconomic fluctuations are primitively the results of many microeconomic shocks. We define fundamental volatility as the volatility that would arise from an economy made entirely of idiosyncratic sectoral or firm-level shocks. Fundamental volatility accounts for the swings in macroeconomic volatility in the major world economies in the past half-century. It accounts for the "great moderation" and its undoing. The initial great moderation is due to a decreasing share of manufacturing between 1975 and 1985. The recent rise of macroeconomic volatility is chiefly due to the growth of the financial sector.

Suggested Citation

  • Vasco Carvalho & Xavier Gabaix, 2013. "The Great Diversification and Its Undoing," American Economic Review, American Economic Association, vol. 103(5), pages 1697-1727, August.
    • Handle: RePEc:aea:aecrev:v:103:y:2013:i:5:p:1697-1727
    Note: DOI: 10.1257/aer.103.5.1697
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    JEL classification:

    • E23 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Production
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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