Working Paper

Financial Frictions, Financial Shocks, and Aggregate Volatility

Abstract: I revisit the Great Inflation and the Great Moderation. I document an immoderation in corporate balance sheet variables so that the Great Moderation is best described as a period of divergent patterns in volatilities for real, nominal and financial variables. A model with time-varying financial frictions and financial shocks allowing for structural breaks in the size of shocks and the institutional framework is estimated. The paper shows that (i) while the Great Inflation was driven by bad luck, the Great Moderation is mostly due to better institutions; (ii) the slowdown in credit spreads is driven by an easier access to credit, while a higher exposure to financial risk determines the immoderation of balance sheet variables; and (iii) financial shocks arise as relevant drivers of U.S. business cycle fluctuations.

Keywords: Great Inflation; Great Moderation; immoderation; financial frictions; financial shocks; structural breaks; Bayesian methods;

JEL Classification: C11; C13; E32; E44;

https://doi.org/10.17016/FEDS.2014.84

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2014-10

Number: 2014-084