Nominal Income and the Great Moderation

The period from 1984 through 2007 was one that exhibited a marked decline in macroeconomic volatility. As such, it is commonly referred to as the Great Moderation. This period has potentially important implications for policy. If, for example, the reduction in volatility was the result of smaller “exogenous shocks” to the economy, then we can largely view the period as one of good luck. However, if the reduction in volatility can be linked to a change in policy, then this period can potentially provide guidance as to how policy should be conducted in the future.

A subset of the literature on the Great Moderation suggests that the reduction in volatility can be explained by a change in monetary policy. In particular, this research largely suggests that the change in monetary policy during the Great Moderation was the Federal Reserve’s commitment to the Taylor principle. Put succinctly, the Taylor principle refers to the idea in which the central bank raises the nominal interest rate more than one-for-one with realized inflation. In other words, the central bank increases the real interest in response to higher realized inflation.

In a new paper, which is forthcoming in the Journal of Macroeconomics, I argue that monetary policy was in fact an important factor in reducing macroeconomic volatility. However, I present an alternative view of the behavior or monetary policy and explicitly reject what I call the “Taylor view.” Specifically, in the paper I make the following argument:

An alternative view of the change in monetary policy from the Great Inflation to the Great Moderation is that there was an overhaul of Federal Reserve doctrine. The radical change in monetary policy was that the Federal Reserve placed emphasis on the role of inflation expectations, knowing that if inflation expectations were stabilized, the price system would restore full employment. The mechanism through which the Federal Reserve sought to achieve this goal was in maintaining low, stable rates of nominal income growth. The commitment to a low, stable rate of nominal income growth regardless of fluctuations in output and employment would give the central bank credibility and therefore stabilize inflation expectations. Full employment was left to the price system.

This understanding of the change in policy is in sharp contrast to the Taylor view. As I argue in the paper, during the Great Inflation period of the 1970s, members of the FOMC regularly asserted that the process of inflation determination had changed. Relying on public statements and personal diary entries from Arthur Burns, I demonstrate that there is little evidence that the Federal Reserve was less concerned with inflation during the 1970s. Rather, the view of Burns and others was that inflation was largely a cost-push phenomenon. Burns thought that incomes policies were necessary to restore price stability and stated that “monetary and fiscal tools are inadequate for dealing with sources of price inflation that are plaguing us now.”

The shift in policy, beginning with Paul Volcker, was an explicit attempt to stabilize inflation expectations and this was done deliberately at first through monetary targeting and ultimately through the stabilization of nominal income growth. Gone were notions of cost-push versus demand-pull inflation. The Fed simply assumed accountability as the creator of inflation.

In addition to examining public statements, I empirically test the hypothesis that the Federal Reserve became more responsive to their forecasts of nominal GDP growth beginning with Paul Volcker. In addition, using simulations (based on simple, conventional sticky-price models), I demonstrate that a monetary policy rule based on the estimated response to these forecasts can potentially explain the reduction in macroeconomic volatility observed during the Great Moderation.

For those interested, a link to the working paper version of the paper can be found here. (The link is a viewable link. To download the paper, go here.)