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Board of Governors of the Federal Reserve System (US)
Finance and Economics Discussion Series
Financial Frictions, Financial Shocks, and Aggregate Volatility
Cristina Fuentes-Albero
Abstract

I revisit the Great Inflation and the Great Moderation for nominal and real variables. 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 was mostly due to better institutions; (ii) the slowdown in the volatility of 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) the improvements in the institutional framework during the Great Moderation mitigate the effects of financial disturbances on the U.S. economy.


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Cristina Fuentes-Albero, Financial Frictions, Financial Shocks, and Aggregate Volatility, Board of Governors of the Federal Reserve System (US), Finance and Economics Discussion Series 2014-84, 19 Sep 2014, revised Jan 2016.
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Keywords: Great Inflation; Great Moderation; Immoderation; Financial frictions; Financial shocks; Structural breaks; Bayesian methods
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