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The Great Moderation and the Financial Cycle

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  • Friedrich Lucke

Abstract

We show that the defining features of the Great Moderation were a shift from output volatility to medium- term fluctuations and a shift in the origin of those fluctuations from the real to the financial sector. We discover a Granger-causal relationship by which financial cycles attenuate short-term business cycle fluc- tuations while they amplify longer-term fluctuations at the same time. As a result, financial shocks system- atically drive medium-term output fluctuations whereas real shocks drive short-term output fluctuations. We use these results to argue that the Great Moderation and Great Recession both result from the same eco- nomic forces. On the theoretical front, we show that long-run risk is a critical ingredient of DSGE models with financial sectors that seek to replicate these shifts. Finally, we used this DSGE model to refine “good luck” and “good policy” hypothesis of the Great Moderation.

Suggested Citation

  • Friedrich Lucke, 2022. "The Great Moderation and the Financial Cycle," Working Papers REM 2022/0238, ISEG - Lisbon School of Economics and Management, REM, Universidade de Lisboa.
    • Handle: RePEc:ise:remwps:wp02382022
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    More about this item

    Keywords

    Great Moderation; Business Cycle; Financial Cycle; Frequency-Domain;
    All these keywords.

    JEL classification:

    • E00 - Macroeconomics and Monetary Economics - - General - - - General
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General

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