Explaining the UK's 'great moderation'

..under inflation targeting the United Kingdom has enjoyed, so far, the most stable macroeconomic environment in its recorded history, with the volatilities of the business-cycle components of real GDP, national accounts aggregates, and inflation measures having been, post-October 1992, systematically lower than for any of the previous monetary regimes/historical periods since the metallic standards era.

But where does this remarkable stability come from? A forthcoming article in the Journal of Money, Credit, and Banking by ECB economist Luca Benati explains: The 'Great Moderation' in the United Kingdom (PDF). The paper compares the likelihood of two main rival explanations – the ‘good luck’ versus ‘good policy’ debate. Benati's main results are summarised below:

So, was it good luck? Based on our results ..it looks like it was indeed. To recapitulate, results from counterfactual simulations show that (1) the Great Inflation was due, to a dominant extent, to large demand non-policy shocks, and to a lesser extent–especially in 1973 and 1979–to supply shocks; (2) imposing the 1970s’ monetary rule over the entire sample period would have made almost no difference in terms of inflation and output growth outcomes; and (3) alternatively, mechanically ‘bringing the Monetary Policy Committee back in time’ would only have had a limited impact on the Great Inflation episode.

The results are, literally, shocking. But how to reconcile these findings with other recent analysis that points to a key role for the Bank of England's independence and inflation targeting regime?

Although in line with the literature on the U.S., these results are quite striking, in particular in the light of the more traditional, narrative approach which suggests that the monetary policy regime has been an important factor in explaining the Great Moderation in the United Kingdom.

One interpretation that could reconcile the two sets of results is based on the ‘indeterminacy hypothesis’ advocated, for the United States, by Clarida, Gali, and Gertler (2000) and Lubik and Schorfheide (2004). In a nutshell, the idea is that monetary policy was not sufficiently stabilising around the time of the Great Inflation, and therefore allowed self-fulfilling sunspot shocks. As our work in progress shows, this could have generated results qualitatively in line with those produced herein, as well as in the related work for the United States.

Comments

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The "Great Inflation" and the "Great Moderation" periods may be explained, to a large extent, by a long-wave boom and bust business cycle (caused by uneven labor supply). Over the Great Inflation period, potential output was overstated, which lead to inflation. Over the Great Moderation period, potential output was understated, which lead to disinflation. Also, errors in monetary policy are more forgiving in a disinflationary period than in an inflationary period.

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What about demographics? Nir Jaimovich and Henry Siu's excellent article, "The Young, the Old, and the Restless" (2007) provided a new perspective to this issue.

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