Learning and the Great Moderation

FRB of St. Louis Working Paper No. 2007-027A

35 Pages Posted: 27 Jun 2007

See all articles by James Bullard

James Bullard

Federal Reserve Banks - Federal Reserve Bank of St. Louis

Aarti Singh

The University of Sydney - School of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: June 2007

Abstract

We study a stylized theory of the volatility reduction in the U.S. after 1984 - the Great Moderation - which attributes part of the stabilization to less volatile shocks and another part to more difficult inference on the part of Bayesian households attempting to learn the latent state of the economy. We use a standard equilibrium business cycle model with technology following an unobserved regime-switching process. After 1984, according to Kim and Nelson (1999a), the variance of U.S. macroeconomic aggregates declined because boom and recession regimes moved closer together, keeping conditional variance unchanged. In our model this makes the signal extraction problem more difficult for Bayesian households, and in response they moderate their behavior, reinforcing the effect of the less volatile stochastic technology and contributing an extra measure of moderation to the economy. We construct example economies in which this learning effect accounts for about 30 percent of a volatility reduction of the magnitude observed in the postwar U.S. data.

Keywords: Bayesian learning, information, business cycles, regime switching

JEL Classification: E3, D8

Suggested Citation

Bullard, James and Singh, Aarti, Learning and the Great Moderation (June 2007). FRB of St. Louis Working Paper No. 2007-027A, Available at SSRN: https://ssrn.com/abstract=996850 or http://dx.doi.org/10.2139/ssrn.996850

James Bullard (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of St. Louis ( email )

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Aarti Singh

The University of Sydney - School of Economics ( email )

Rm 370 Merewether (H04)
The University of Sydney
Sydney, NSW 2006 2008
Australia

HOME PAGE: http://sydney.edu.au/arts/economics/staff/academic/aarti_singh.shtml