Is the Great Moderation Ending?——UK and US Evidence

ABSTRACT

The Great Moderation, the significant decline in the variability of economic activity, provides a most remarkable feature of the macroeconomic landscape in the last twenty years. A number of papers document the beginning of the Great Moderation in the US and the UK. In this paper, we use the Markov regime-switching models to document the end of the Great Moderation. The Great Moderation in the US and the UK begin at different point in time. The explanations for the Great Moderation fall into generally three different categories—good monetary policy, improved inventory management, or good luck. The end of the Great Moderation, however, occurs at approximately the same time in both the US and the UK. It seems unlikely that good monetary policy would turn into bad policy or that better inventory management would turn into worse management. Rather, the likely explanation comes from bad luck. Two likely culprits exist—energy-price and housing-price shocks.

The Great Moderation, the significant decline in the variability of economic activity, provides a most remarkable feature of the macroeconomic landscape in the last twenty years. A number of papers document the beginning of the Great Moderation in the US and the UK. In this paper, we use the Markov regime-switching models to document the end of the Great Moderation. The Great Moderation in the US and the UK begin at different point in time. The explanations for the Great Moderation fall into generally three different categories—good monetary policy, improved inventory management, or good luck. The end of the Great Moderation, however, occurs at approximately the same time in both the US and the UK. It seems unlikely that good monetary policy would turn into bad policy or that better inventory management would turn into worse management. Rather, the likely explanation comes from bad luck. Two likely culprits exist—energy-price and housing-price shocks.

Cite this paper

nullG. Canarella, W. Fang, S. Miller and S. Pollard, "Is the Great Moderation Ending?——UK and US Evidence,"*Modern Economy*, Vol. 1 No. 1, 2010, pp. 17-42. doi: 10.4236/me.2010.11002.

nullG. Canarella, W. Fang, S. Miller and S. Pollard, "Is the Great Moderation Ending?——UK and US Evidence,"

References

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[31] J. D. Hamilton and R. Susmel, “Autoregressive CondiTional Heteroskedasticity and Changes in Regime,” Journal of Econometrics, Vol. 64, No. 1-2, 1994, pp. 307-333.

[32] J. Kim, C. R. Nelson and R. Startz, “Testing for Mean Reversion in Heteroskedastic Data Based on Gibbs Sampling Augmented Randomization,” Journal of Empirical Finance, Vol. 5, No. 2, 1998, pp. 131-154.

[33] R. Bhar and S. Hamori, “Alternative Characterization of the Volatility in the Growth Rate of Real GDP,” Japan and the World Economy, Vol. 15, No. 2, 2003, pp. 223-231.

[34] F. X. Diebold, “Comments on Modelling the Persistence of Conditional Variance,” Econometric Reviews, Vol. 5, No. 1, 1986, pp. 51-56.

[35] R. F. Engle and T. Bollerslev, “Modelling the Persistence of Conditional Variance,” Econometric Reviews, Vol. 5, No. 1, 1986, pp. 1-50.

[36] T. Mikosch and C. Stărică, “Non-Stationarities in Financial Time Series, the Long-Range Dependence, and the IGARCH Effects,” Review of Economics and Statistics, Vol. 86, No. 1, 2004, pp. 378-390.

[37] E. Hillebrand, “Neglecting Parameter Changes in GARCH Models,” Journal of Econometrics, Vol. 129, No. 1-2, 2005, pp. 121-138.

[38] W. Kramer and B. T. Azamo, “Structural Change and Estimated Persistence in the GARCH(1,1)-Model,” Economics Letters, Vol. 97, No. 1, 2007, pp. 17-23.

[39] S. Gray, “Modeling the Conditional Distribution of Interest Rates as a Regime Switching Process,” Journal of Financial Economics, Vol. 42, No. 1, 1996, pp. 27-62.

[40] M. Sola and A. G. Timmerman, “Fitting the Moments: A Comparison of ARCH and Regime-Switching Models for Daily Stock Returns,” Working Paper, London Business School, 1994.

[41] R. Fletcher, “A New Approach to Variable Metric Algorithm,” Computer Journal, Vol. 13, No. 3, 1970, pp. 317-322.

[42] R. B. Davies, “Hypothesis Testing when a Nuisance Para-Meter is Present Only under the Alternative,” Biometrika, Vol. 74, No. 1, 1987, pp. 33-43.

[43] Kanas and M. Genius, “Regime (Non)Stationarity in the US/UK Real Exchange Rate,” Economics Letters, Vol. 87, No. 3, 2005, pp. 407-413.

[44] L. Ramchand and R. Susmel, “Cross Correlations across Major International Markets,” Journal of Empirical Finance, Vol. 5, No. 4, 1998, pp. 397-416.

[45] C. G. Broyden, “The Convergence of a Class of Double-Rank Minimization Algorithms,” IMA Journal of Applied Mathematics, Vol. 6, No. 1, 1970, pp. 76-90.

[46] D. Goldfarb, “A Family of Variable Metric Methods Derived by Variational Means,” Mathematical Computa- tion, Vol. 24, 1970, pp. 23-26.

[47] D. F. Shanno, “Conditioning of Quasi-Newton Methods for Function Minimization,” Mathematics of Computation, Vol. 24, No. 111, 1970, pp. 647-656.

[48] E. K. Berndt, B. H. Hall, R. E. Hall and J. A. Hausmann, “Estimation and Inference in Nonlinear Structural Models,” Annals of Economic and Social Measurement, Vol. 3, No. 4, 1974, pp. 653-665.

[49] D. Brunner, “Conditional Asymmetries in Real GDP: A Semiparametric Approach,” Journal of Business and Economic Statistics, Vol. 10, No. 1, 1992, pp. 65-72.

[50] D. Brunner, “On the Dynamic Properties of Asymmetric Models of Real GDP,” The Review of Economics and Statistics, Vol. 79, No. 2, 1997, pp. 321-326.

[51] M. V. French and D. Sichel, “Cyclical Patterns in the Variance of Economic Activity,” Journal of Business and Economic Statistics, Vol. 11, No. 1, 1993, pp. 113-119.

[52] B. E. Hansen, “The Likelihood Ratio Test Under Non- standard Conditions: Testing the Markov Switching Model of GNP,” Journal of Applied Econometrics, Vol. 7, 1992, pp. S61-S82.

[53] R. Garcia, “Asymptotic Null Distribution of the Likelihood Ratio Test in Markov Switching Models,” Interna- tional Economic Review, Vol. 39, No. 3, 1998, pp. 763- 788.

[54] M. Liu, “Modelling Long Memory in Stock Market Volatility,” Journal of Econometrics, Vol. 99, No. 1, 2000, pp. 139-171.

[55] C. S. Wong and W. K. Li, “On a Mixture Autoregressive Conditional Heteroskedastic Model,” Journal of the American Statistical Association, Vol. 96, No. 455, 2001, pp. 982-995.

[56] C. M. Reinhart and K. S. Rogoff, “Is the 2007 US Sub- Prime Financial Crisis So Different? An International Historical Comparison,” American Economic Review: Papers and Proceedings, Vol. 98, No. 2, 2008, pp. 339- 344.

[1] R. F. Engle, “Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of United Kingdom Inflation,” Econometrica, Vol. 50, No. 4, 1982, pp. 987- 1007.

[2] T. Bollerslev, “Generalized Autoregressive Conditional Heteroskedasticity,” Journal of Econometrics, Vol. 31, No. 3, 1986, pp. 307-327.

[3] Klaassen, “Improving GARCH Volatility Forecasts with Regime-Switching GARCH,” Empirical Economics, Vol. 27, No. 2, 2002, pp. 363-394.

[4] C. G. Lamoureux and W. D. Lastrapes, “Persistence in Variance, Structural Change and the GARCH Model,” Journal of Business and Economic Statistics, Vol. 8, No. 2, 1990, pp. 225-234.

[5] A. Timmerman, “Moments of Markov Switching Models,” Journal of Econometrics, Vol. 96, No. 1, 2000, pp. 75- 111.

[6] W. Fang, S. M. Miller and C. Lee, “Cross-Country Evidence on Output Growth Volatility: Nonstationary Variance and GARCH Models,” Scottish Journal of Political Economy, Vol. 55, No. 4, 2008, pp. 509-541.

[7] A. Sansó, V. Arragó and J. L. Carrion, “Testing for Change in the Unconditional Variance of Financial Time Series,” Revista de Economiá Financiera, Vol. 4, No. 4, 2004, pp. 32-53.

[8] W. Fang and S. M. Miller, “The Great Moderation and the Relationship between Output Growth and its Volatility,” Southern Economic Journal, Vol. 74, No. 3, 2008, pp. 819-838.

[9] J. D. Hamilton, “Rational-Expectations Econometric Analysis of Changes in Regime: An Investigation of the Term Structure of Interest Rates,” Journal of Economic Dynamics and Control, Vol. 12, No. 2-3, 1988, pp. 385- 423.

[10] J. D. Hamilton, “A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle,” Econometrica, Vol. 57, No. 2, 1989, pp. 357-384.

[11] J. Kim and C. R. Nelson, “Has the U.S. Economy Become More Stable? A Bayesian Approach Based on a Markov-Switching Model of the Business Cycle,” Review of Economics and Statistics, Vol. 81, No. 4, 1999, pp. 608-616.

[12] M. M. McConnell and G. Perez-Quiros, “Output Fluctuations in the United States: What has Changed since the Early 1980’s?” American Economic Review, Vol. 90, No. 5, 2000, pp. 1464-1476.

[13] O. J. Blanchard and J. Galí, “The Macroeconomic Effects of Oil Price Shocks: Why are the 2000s So Different from the 1970s?” MIT Department of Economics Working Paper No. 07-21, 2007.

[14] O. J. Blanchard and J. Simon, “The Long and Large Decline in U. S. Output Volatility,” Brookings Papers on Economic Activity, Vol. 2001, No. 1, 2001, pp. 135-164.

[15] T. C. Mills and P. Wang, “Have Output Growth Rates Stabilized? Evidence from the G-7 Economies,” Scottish Journal of Political Economy, Vol. 50, No. 3, 2003, pp. 232-246.

[16] P. M. Summers, “What Caused the Great Moderation? Some Cross-Country Evidence,” Economic Review, Federal Reserve Bank of Kansas City, 2005, pp. 5-32.

[17] J. H. Stock and M. W. Watson, “Understanding Changes in International Business Cycle Dynamics,” Journal of the European Economic Association, Vol. 3, No. 5, 2005, pp. 968-1006.

[18] C. Kent, K. Smith and J. Holloway, “Declining Output Volatility: What Role for Structural Change?” In: C. Kent and D. Norman, Eds., The Changing Nature of the Business Cycle, Reserve Bank of Australia, 2005, pp. 146-180.

[19] S. G. Cecchetti, A. Flores-Lagunes and S. Krause, “Assessing the Sources of Changes in the Volatility of Real Growth,” In: C. Kent and D. Norman, Eds., The Changing Nature of the Business Cycle, Reserve Bank of Australia, 2005, pp. 115-138.

[20] J. H. Stock and M. W. Watson, “Has the Business Cycle Changed? Evidence and Explanations,” Monetary Policy and Uncertainty: Adapting to a Changing Economy, Proceedings of Symposium sponsored by Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 2003, pp. 9-56.

[21] S. Ahmed, A. Levin and B. A. Wilson, “Recent U.S. Macroeconomic Stability: Good Policies, Good Practices, or Good Luck?” Review of Economics and Statistics, Vol. 86, No. 3, 2004, pp. 824-832.

[22] R. Clarida, J. Galí and M. Gertler, “Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory,” Quarterly Journal of Economics, Vol. 115, No. 1, 2000, pp. 147-180.

[23] B. S. Bernanke, “The Great Moderation,” Speech at Eastern Economic Association, Washington, February 20 2004.

[24] J. H. Stock and M. W. Watson, “Has the Business Cycle Changed and Why?” In: M. Gertler and K. Rogoff, Eds., NBER Macroannual 2002, MIT Press, Cambridge, 2002, pp. 159-218.

[25] G. E. Primiceri, “Time Varying Structural Vector Autore-Gressions and Monetary Policy,” Review of Economic Studies, Vol. 72, No. 3, 2005, pp. 821-852.

[26] C. Sims and T. Zha, “Were There Regime Switches in U.S. Monetary Policy?” American Economic Review, Vol. 96, No. 1, 2006, pp. 54-81.

[27] L. Gambetti, E. Pappa and F. Canova, “The Structural Dynamics of US Output and Inflation: What Explains the Changes?” Journal of Money, Credit and Banking, Vol. 40, No. 2-3, 2006, pp. 369-388.

[28] T. Lubik and F. Schorfheide, “Testing for Indeterminacy: An Application to U. S. Monetary Policy,” American Economic Review, Vol. 94, No. 1, 2004, pp. 190-217.

[29] J. Boivin and M. Giannoni, “Has Monetary Policy Become More Effective?” The Review of Economics and Statistics, Vol. 88, No. 3, 2006, pp. 445-462.

[30] L. Benati and P. Surico, “VAR Analysis and the Great Moderation, European Central Bank,” Working Paper # 866, February 2008.

[31] J. D. Hamilton and R. Susmel, “Autoregressive CondiTional Heteroskedasticity and Changes in Regime,” Journal of Econometrics, Vol. 64, No. 1-2, 1994, pp. 307-333.

[32] J. Kim, C. R. Nelson and R. Startz, “Testing for Mean Reversion in Heteroskedastic Data Based on Gibbs Sampling Augmented Randomization,” Journal of Empirical Finance, Vol. 5, No. 2, 1998, pp. 131-154.

[33] R. Bhar and S. Hamori, “Alternative Characterization of the Volatility in the Growth Rate of Real GDP,” Japan and the World Economy, Vol. 15, No. 2, 2003, pp. 223-231.

[34] F. X. Diebold, “Comments on Modelling the Persistence of Conditional Variance,” Econometric Reviews, Vol. 5, No. 1, 1986, pp. 51-56.

[35] R. F. Engle and T. Bollerslev, “Modelling the Persistence of Conditional Variance,” Econometric Reviews, Vol. 5, No. 1, 1986, pp. 1-50.

[36] T. Mikosch and C. Stărică, “Non-Stationarities in Financial Time Series, the Long-Range Dependence, and the IGARCH Effects,” Review of Economics and Statistics, Vol. 86, No. 1, 2004, pp. 378-390.

[37] E. Hillebrand, “Neglecting Parameter Changes in GARCH Models,” Journal of Econometrics, Vol. 129, No. 1-2, 2005, pp. 121-138.

[38] W. Kramer and B. T. Azamo, “Structural Change and Estimated Persistence in the GARCH(1,1)-Model,” Economics Letters, Vol. 97, No. 1, 2007, pp. 17-23.

[39] S. Gray, “Modeling the Conditional Distribution of Interest Rates as a Regime Switching Process,” Journal of Financial Economics, Vol. 42, No. 1, 1996, pp. 27-62.

[40] M. Sola and A. G. Timmerman, “Fitting the Moments: A Comparison of ARCH and Regime-Switching Models for Daily Stock Returns,” Working Paper, London Business School, 1994.

[41] R. Fletcher, “A New Approach to Variable Metric Algorithm,” Computer Journal, Vol. 13, No. 3, 1970, pp. 317-322.

[42] R. B. Davies, “Hypothesis Testing when a Nuisance Para-Meter is Present Only under the Alternative,” Biometrika, Vol. 74, No. 1, 1987, pp. 33-43.

[43] Kanas and M. Genius, “Regime (Non)Stationarity in the US/UK Real Exchange Rate,” Economics Letters, Vol. 87, No. 3, 2005, pp. 407-413.

[44] L. Ramchand and R. Susmel, “Cross Correlations across Major International Markets,” Journal of Empirical Finance, Vol. 5, No. 4, 1998, pp. 397-416.

[45] C. G. Broyden, “The Convergence of a Class of Double-Rank Minimization Algorithms,” IMA Journal of Applied Mathematics, Vol. 6, No. 1, 1970, pp. 76-90.

[46] D. Goldfarb, “A Family of Variable Metric Methods Derived by Variational Means,” Mathematical Computa- tion, Vol. 24, 1970, pp. 23-26.

[47] D. F. Shanno, “Conditioning of Quasi-Newton Methods for Function Minimization,” Mathematics of Computation, Vol. 24, No. 111, 1970, pp. 647-656.

[48] E. K. Berndt, B. H. Hall, R. E. Hall and J. A. Hausmann, “Estimation and Inference in Nonlinear Structural Models,” Annals of Economic and Social Measurement, Vol. 3, No. 4, 1974, pp. 653-665.

[49] D. Brunner, “Conditional Asymmetries in Real GDP: A Semiparametric Approach,” Journal of Business and Economic Statistics, Vol. 10, No. 1, 1992, pp. 65-72.

[50] D. Brunner, “On the Dynamic Properties of Asymmetric Models of Real GDP,” The Review of Economics and Statistics, Vol. 79, No. 2, 1997, pp. 321-326.

[51] M. V. French and D. Sichel, “Cyclical Patterns in the Variance of Economic Activity,” Journal of Business and Economic Statistics, Vol. 11, No. 1, 1993, pp. 113-119.

[52] B. E. Hansen, “The Likelihood Ratio Test Under Non- standard Conditions: Testing the Markov Switching Model of GNP,” Journal of Applied Econometrics, Vol. 7, 1992, pp. S61-S82.

[53] R. Garcia, “Asymptotic Null Distribution of the Likelihood Ratio Test in Markov Switching Models,” Interna- tional Economic Review, Vol. 39, No. 3, 1998, pp. 763- 788.

[54] M. Liu, “Modelling Long Memory in Stock Market Volatility,” Journal of Econometrics, Vol. 99, No. 1, 2000, pp. 139-171.

[55] C. S. Wong and W. K. Li, “On a Mixture Autoregressive Conditional Heteroskedastic Model,” Journal of the American Statistical Association, Vol. 96, No. 455, 2001, pp. 982-995.

[56] C. M. Reinhart and K. S. Rogoff, “Is the 2007 US Sub- Prime Financial Crisis So Different? An International Historical Comparison,” American Economic Review: Papers and Proceedings, Vol. 98, No. 2, 2008, pp. 339- 344.