Can Financial Innovation Help to Explain the Reduced Volatility of Economic Activity?

Abstract

Bridges, and Adam McGlashan for research assistance. An appendix available from the authors includes tables and figures not included in the published version of the paper as well as a brief review of the evidence regarding the leading hypotheses for the moderation in economic activity. The views expressed in the paper are our own and not necessarily those of the Federal Reserve Board or other members of its staff. 2 Can Financial Innovation Help to Explain the Reduced Volatility of Economic Activity?

The role of credit in the Great Moderation: A multivariate GARCH approach

“…These revolve around financial innovations (Dynan et al, 2006;Guerron-Quintana, 2009), financial sector development (Easterly et al, 2000), changing responses to monetary shocks and improvements in monetary policy (Clarida et al, 2000;Bernanke, 2004;Lubik and Schirfheide 2004;Boivin and Giannoni, 2006), and innovations in financial markets and in the dynamics of inflation (Blanchard and Simon, 2001). …”

“…Studies that relate specifically to the hypothesis that growth in financial wealth has smoothed GDP growth include Dynan et al (2006), who show how financial innovation smoothed financial variables (such as returns on financial assets). This signalled (correctly or falsely) low risk levels to both banks and real-sector actors, encouraging them to lend and borrow more, respectively.…”

“…Giannone et al (2010) find that the decline in the volatility of GDP growth since the mid 1980s is not due to a decline in the volatility of exogenous shocks, but rather a change in their propagation mechanism, which points to the role of financial intermediation. Dynan et al (2006) show that that, while aggregate economic activity has become less volatile over time, individual households appear to have faced more volatile economic circumstances. The explanation is in 1 The end data of 2008 follows e.g.…”

It ain’t over till it’s over: A global perspective on the Great Moderation-Great Recession interconnection

“…Other contributions focus on the role of better monetary policy in reducing aggregate volatility (Clarida, Gal, and Gertler 2000), shifting the economy away from indeterminacy and leading to an environment of price stability (Lubik and Schorfheide, 2004;Coibion and Gorodnichenko 2011). Finally, several sources of structural change, potentially responsible for declining output volatility, have been explored, such as (i) improved inventory management through the intensive adoption of information technology (McConnell and Pérez-Quiros, 2000;Davis and Kahn 2008); (ii) the expansion of the tertiary sector and contraction of energy-related and heavy industry sectors (Carvalho and Gabaix 2013); (iii) the decline in aggregate consumption and investment volatility due to the dominance of permanent technological shocks (Blanchard and Simon 2001); (iv) changes in the correlation between productivity and hours (Gal and Gambetti 2009); lower sensitivity of aggregate expenditure to current income and interest rates due to financial innovation (Dynan, Elmendorf, and Sichel 2006).…”

On the Change in the Austrian Business Cycle

“…They cover good policy, good luck and good practices. The first point usually refers to improvements in monetary policy (Clarida et al 2000), the second stresses good luck in terms of smaller and fewer shocks (Stock & Watson 2002), while the third regards changes in the economic structure like sectoral shifts (Buch et al 2004), globalisation and openness to trade (Buch 2002, Cavallo & Frankel 2008, technological developments (Arias et al 2007), inventory management (Kahn et al 2002, Irvine & Schuh 2005, demographic changes (Jaimovich & Siu 2009) or financial openness and innovations (Buch et al 2005, Dynan et al 2006 as the main factors for the reduced cyclical volatility. Especially the latter were recently discussed in the course of the financial crisis and the global recession starting at the end of 2008.…”