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The Great Diversification and its Undoing

  • Vasco Carvalho
  • Xavier Gabaix

We investigate the hypothesis that macroeconomicfluctuations are primitively the results of many microeconomic shocks, and show that it has significant explanatory power for the evolution of macroeconomic volatility. We define "fundamental" volatility as the volatility that would arise from an economy made entirely of idiosyncratic microeconomic shocks, occurring primitively at the level of sectors orfirms. In its empirical construction, motivated by a simple model, the sales share of different sectors vary over time (in a way we directly measure), while the volatility of those sectors remains constant. Wefind that fundamental volatility accounts for the swings in macroeconomic volatility in the US and the other major world economies in the past half century. It accounts for the "great moderation" and its undoing. Controlling for our measure of fundamental volatility, there is no break in output volatility. The initial great moderation is due to a decreasing share of manufacturing between 1975 and 1985. The recent rise of macroeconomic volatility is due to the increase of the size of thefinancial sector. We provide a model to think quantitatively about the large comovement generated by idiosyncratic shocks. As the origin of aggregate shocks can be traced to identifiable microeconomic shocks, we may better understand the origins of aggregatefluctuations.

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Paper provided by Barcelona Graduate School of Economics in its series Working Papers with number 422.

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Date of creation: Jan 2010
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Handle: RePEc:bge:wpaper:422
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