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The Great Moderation and the New Business Cycle

Spehar, Ann O'Ryan (2008): The Great Moderation and the New Business Cycle. Published in: World Economics Journal , Vol. 10, No. 1 (2009)

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Abstract

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. It is thought that these new economies have specific characteristics that generate endogenous financial business cycles. That is, 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 in the probability of episodes of financial instability (Borio 2003). In fact, within these new economies inflation shows up first as excess demand within credit aggregates and asset prices rather than in the traditional goods and services markets. This means that a financial crisis could occur without inflation ever having occurred within the broader economy. If asset bubbles are left unattended the resulting implosion of the bubbles can create virulent deflationary episodes. And it is the unwinding of the financial imbalances caused by the bubbles that are the source of financial instability. And it is worth noting that minimizing the deflationary impact will not stop the necessary unwinding and required rebalancing. Again, this paper does not intend to define a model but instead simply lays out the ideas and theories behind this new modeling approach. This paper will first compare the traditional to the new modeling approach by first describing the economic environment that creates the business cycle. Secondly it will compare the two paradigms and explain how each generates different questions and answers in monitoring and explaining economic stability. Finally, I touch on a few of the unique challenges facing our current crisis within the United States.

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