The Great Moderation and the New Business Cycle

There is a new approach to modeling business cycles that is gaining acceptance. It appears that there is good evidence that this approach may have a great deal to offer in understanding the causes and processes of major economic business cycles associated with financial crisis. This paper does not intend to define a mathematical model but instead describes the ideas and theories behind this new approach. In addition, this paper addresses a few of the unique challenges officials within the United States face with the current global crisis. The new approach has at its core the belief that the structure of our current economy, as well as many European economies, has changed significantly. Starting around 1983-1985 a structural break occurred that resulted in a period where changes in GDP, consumption and inflation ceased to experience high volatility. This period has been dubbed “The Great Moderation” and it is significant. The standard deviation during the years 1985-2004 was but one-half the standard deviation of the quarterly growth rate of real gross domestic product between the years 1960-1984. A variety of hypothesis for this period has been put forth of which will not be discussed in this paper. More importantly here, is that these new economies are subject to business cycles that are endogenous in nature and are highly correlated with financial crisis. It is believed that these new economies have specific characteristics that generate these financial business cycles. These cycles are not triggered by exogenous supply or demand shocks that throw an economy off of a steady state but instead are an endogenous force within the gears of the system itself that creates imbalances that can build up without any noticeable increase in inflation - the traditional parameter typically used to monitor imbalances. The main characteristic of this new era of Great Moderation is rapidly rising growth coupled with low and stable prices which is highly correlated with an increase (This abstract was borrowed from another version of this item.)