THE SOURCES OF THE DECLINE IN U.S. OUTPUT VOLATILITY

I. INTRODUCTION The recent macroeconomic literature provides evidence of decreased volatility of U.S. output since the middle of the 1980s. The performance of the U.S. economy for the last two decades seems to be quite different in structure compared to previous years. Several studies show that the volatility, as measured by standard deviations of quarterly growth rates of real GDP from 1950 through 1983, was over twice as large as that for 1984-1999. (1) These studies conclude that in terms of the volatility of U.S. output, the U.S. economy has stabilized since the early 1980s and that the recent decline in output volatility occurs in the first quarter of 1984. (2) The sources of a structural change in the U.S. economy have been the subject of many studies. Assuming that we know the date of the structural change, the next question should be "What are the sources of the structural change?" There have been a growing number of studies addressing the sources of the decline in U.S. output volatility, but the question is still very much open for debates. The conclusions of recent research on the subject can be summarized in four ways: (1) good luck, (2) good policy, (3) good technology (good business practice), and (4) a combination of (1), (2), and (3). First, "good luck" means that the U.S. economy enjoyed smaller shocks. Second, "good policy" means that the Federal Reserve has improved monetary policy tools since 1979, resulting in the U.S. economy having more stable output and low rates of inflation. Finally, "good technology" means that better business practices may have reduced volatility in production. Finding the source of the structural change is very important because the relative importance of these competing explanations has different implications for the sustainability of the volatility reduction and the evaluation of policy effectiveness. Additionally, accounting for this structural change has important implications for the descriptive and forecasting abilities of these models. (3) In this paper, we concentrate on two factors, shocks and the structure of the U.S. economy, to determine the sources of the decline in output volatility. Assuming that the break happened in the first quarter of 1984, we estimate the structural vector autoregression (VAR) models suggested by Blanchard and Quah (1989) before and after the 1984 structural break point. (4) Using the estimation results, we find that the magnitude of both supply (permanent) and demand (transitory) shocks in the pre-1984 period is greater than that in the post-1984 period, which implies that the good luck hypothesis is supported. We also find that in the post-1984 period both shocks have decreased in magnitude and the relative importance of the transitory shocks has decreased drastically compared to the pre-1984 period. One possible explanation is that the Federal Reserve Bank might have undertaken its monetary policy more efficiently in the post-1984 period, leading to fewer demand shocks to the economy, which supports the good policy hypothesis. Another possible explanation is that firms might have employed such better business practices as improved inventory management. However, we do not know which are the sources of the decline in output volatility. We perform some counterfactual analyses to further investigate this problem. The results using a two-variable VAR model seem to suggest that shocks, not the structure, are the primary source of the decline in output volatility. The results using a five-variable VAR model, however, imply a larger role for the structure compared to the two-variable VAR model. Although it does not clearly provide the sources of the decline in output volatility, the use of such variables as federal funds rate and inventory/GDP in the five-variable VAR model indicates that all of good luck, good monetary policies, and better business practices might have played a role in reducing U. …