of the Federal Reserve Bank of St. Louis

In this paper the authors report the results of the estimation of a rich dynamic stochastic general equilibrium (DSGE) model of the U.S. economy with both stochastic volatility and parameter drifting in the Taylor rule. They use the results of this estimation to examine the recent monetary history of the United States and to interpret, through this lens, the sources of the rise and fall of the Great Inflation from the late 1960s to the early 1980s and of the Great Moderation of business cycle fluctuations between 1984 and 2007. Their main findings are that, while there is strong evidence of changes in monetary policy during Chairman Paul Volcker’s tenure at the Federal Reserve, those changes contributed little to the Great Moderation. Instead, changes in the volatility of structural shocks account for most of it. Also, although the authors find that monetary policy was different under Volcker, they do not find much evidence of a big difference in monetary policy among the tenures of Chairmen Arthur Burns, G. William Miller, and Alan Greenspan. The difference in aggregate outcomes across these periods is attributed to the time-varying volatility of shocks. The history for inflation is more nuanced, as a more vigorous stand against it would have reduced inflation in the 1970s, but not completely eliminated it. In addition, they find that volatile shocks (especially those related to aggregate demand) were important contributors to the Great Inflation.

One basic feature of aggregate data is the presence of time-varying variance in real and nominal variables. Periods of high volatility are followed by periods of low volatility. For instance, the turbulent 1970s were followed by the much more tranquil times of the great moderation from 1984 to 2007. Modeling these movements in volatility is important to understand the source of aggregate fluctuations, the evolution of the economy, and for policy analysis. In this chapter, we first review the different mechanisms proposed in the literature to generate changes in volatility similar to the ones observed in the data. Second, we document the quantitative importance of timevarying volatility in aggregate time series. Third, we present a prototype business cycle model with time-varying volatility and explain how it can be computed and how it can be taken to the data using likelihood-based methods and non-linear filtering theory. Fourth, we present two “real life”applications. We conclude by summarizing what we know and what we do not know about volatility in macroeconomics and by pointing out some directions for future research.

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We study the effects of changes in uncertainty about future fiscal policy on aggregate economic activity. In light of large fiscal deficits and high public debt levels in the U.S., a fiscal consolidation seems inevitable. However, there is notable uncertainty about the policy mix and timing of such a budgetary adjustment. To evaluate the consequences of the increased uncertainty, we first estimate tax and spending processes for the U.S. that allow for timevarying volatility. We then feed these processes into an otherwise standard New Keynesian business cycle model calibrated to the U.S. economy. We find that fiscal volatility shocks can have a sizable adverse effect on economic activity.

We estimate a model for the US economy that allows for a switch from a non-Ricardian to a Ricardian regime. We find that the change occurred in the early ’80s and we point out the following results. First, if the Ricardian regime had been in place since 1955 or if agents had anticipated the switch, the Great Inflation would not have occurred and debt would have been higher. This is because the rise in trend inflation and the decline in debt of the ’70s are caused by a series of fiscal shocks that are inflationary only under the non-Ricardian regime. Second, the reversal in the debt-to-GDP ratio dynamics, the sudden drop in inflation, and the fall in output of the early ’80s are explained by the regime switch itself. If the regime change had not occurred, inflation would have been high for another ten years. Third, the regime switch can account for the change in the persistence and volatility of inflation.