Media Briefings

Explaining The 'Great Moderation': The Impact Of Productivity, Improved Monetary

  • Published Date: March 2010

Reduced reliance on oil and the absence of big oil supply shocks played a major role in the ‘taming’ of inflation over the past quarter century, accounting for nearly half of the reduction in price volatility. Improved monetary policy accounted for the other half.

These are among the findings of research by Anton Nakov and Andrea Pescatori, which examines the importance of various factors in explaining the ‘Great Moderation’ in inflation and the business cycle before the start of the crisis in 2007.

Their study, published in the March 2010 Economic Journal, also finds that changes in oil markets accounted for around a third of the reduced volatility of GDP, and monetary policy mattered very little. Instead, the main explanation for the less volatile business cycle was reduced variation in productivity growth, which may have been sheer luck.

Looking at a chart of US GDP growth for the 50 years up to 2007, when ‘all hell broke loose’, it is puzzling to see the remarkable decline in the volatility of that variable beginning around 1984. No less surprising is the coincident ‘taming’ of US inflation (see Figure 1).

It remains to be seen whether the global crisis of 2007-09 will bring an end to what has come to be known as the period of the Great Moderation. Yet the fact is that for over 25 years since the mid-1980s, the volatility of key macroeconomic variables in many industrialised countries remained at roughly half of its pre-1984 level, a curious economic phenomenon that requires explanation.

Economists have focused mainly on three possible explanations for the Great Moderation: less volatile productivity growth; improvements in monetary policy; and ‘structural’ changes in the economy, which made it less vulnerable to shocks.

The study by Nakov and Pescatori assesses the relative importance of each of these factors, focusing in particular on the role that structural changes in oil markets may have played in reducing macroeconomic volatility of the United States.

Such changes are a natural candidate for an explanation, given that a similar and roughly coincident pattern of volatility moderation has been observed in a number of industrialised countries, which are likely to be affected by global oil shocks in a similar way.

For one thing, in the period 1984-2007, there have been fewer major oil supply shocks (with the exception of the 1991 Persian Gulf War) compared with the more volatile years pre-1984. At the same time, decreasing energy expenditure as a share of GDP may have made economies more resilient to oil supply shocks in the recent period.

One of the novel features of this study is that the researchers try to distinguish between supply and demand determinants of the oil price. Most previous studies assume that oil price changes invariably occurred for exogenous reasons – that is, in isolation from the prevailing macroeconomic conditions.

This may be true for some oil price shocks, for example, a war affecting a major oil producer. But in general, the oil price should be affected by global demand factors as well: other things equal, a booming world economy is one in which the oil price is expected to rise for good reasons.

The authors use their model to infer the size of pre- and post-1984 oil supply shocks from the evidence on oil price changes, and compute the reduction in the share of oil expenditure in GDP directly from the data. They then assess the importance of these two changes for the Great Moderation alongside the two other competing factors –improved monetary policy and less volatile productivity.

The model predicts that a combination of all four factors explains a 52% reduction in the volatility of GDP growth and a 58% reduction in the volatility of inflation since 1984, both of which are quite close to what is actually observed. Table 1 shows the contributions of each factor to these totals.

The authors find that although improved monetary policy is the biggest single factor in the reduced volatility of inflation, changing oil markets have contributed too, with the reduced reliance on oil accounting for one-third, and the reduced prevalence of major oil supply shocks accounting for an additional 17% of the reduced volatility of inflation.

By contrast, the authors conclude that neither monetary policy nor changes in oil markets are the main explanation for the reduced volatility of GDP. According to their calculations, the reduced reliance on oil and increased stability of oil markets might account for roughly a third of the reduction in GDP volatility, while monetary policy mattered very little.

Instead, the biggest factor for the lower volatility of GDP growth was a reduction in the variation of productivity, which, while unexplained by their model, may have been a matter of sheer luck.


Notes for editors: ‘Oil and the Great Moderation’ by Anton Nakov and Andrea Pescatori is published in the March 2010 issue of the Economic Journal.

Anton Nakov is at the Banco de Espana. Andrea Pescatori is at the Federal Reserve Bank of Cleveland.

For further information: contact Romesh Vaitilingam on 07768-661095 (email:; or Anton Nakov via email: