The Volatility of the Output Gap in the G7
Barrell, Ray, Gottschalk, Sylvia, National Institute Economic Review
We investigate declining output volatility in the G7 since 1970 in a panel context, seeking to explain the causes of the decline. We show that there is a significant role for both net financial wealth and trade openness as well as inflation volatility, even though previous studies have ignored the fact that it may be endogenous and its role therefore spurious. However, its importance clearly varies over time and across countries, and it appears less important as an explanation of declining volatility in the US than it does in the UK. Changes in openness appear to be at least as important in explaining the decline in US output volatility.
Volatility in output and inflation increases risk and premia associated with risk in the economy. Increases in risk are likely to reduce equilibrium output, and may lead to both higher saving and a lower capital stock, which may in turn lead to greater capital outflows in an open economy. (1) Policies that reduce anticipated and unanticipated volatility will therefore raise output and welfare in the longer run. It is now well documented that output volatility in the US has declined dramatically in the past twenty years, particularly during the 1990s, as shown by Blanchard and Simon (2001) and Stock and Watson (2002), among others. Blanchard and Simon (2000) find evidence that output volatility has declined with inflation volatility and suggest with Romer (1999) that more effective monetary and fiscal policies may have contributed to the reduction of business cycle volatility. All these authors also agree that the shocks that hit the G-7 economies have been smaller in number and size in the past twenty years, and that this must account for some of the decline in volatility. In this paper, we examine the systemic causes of the decline of the output gap volatility in the G7 economies between 1970 and 2001.
Improvements in the operation of monetary and fiscal policy have probably contributed to increased stability in the past 30 years, but macroeconomic policies are not the only factor contributing to this improvement in performance. Policies that make markets more efficient and effective also help stabilise the economy in the face of shocks, and these may have been at least as important as improvements in macro policy design in increasing stability. We find evidence that the increase in openness to trade and increases in holdings of financial wealth, along with the reduction of inflation volatility, can account for the reduction of the volatility of the output gap during the past three decades in the G7. Our results are consistent with the theoretical literature that shows that trade and financial liberalisation allow risk-sharing and that more sophisticated financial markets help individuals smooth their consumption decisions over time, as well as supporting the view that better monetary and fiscal policies help reduce output volatility.
2. Declining output volatility and its causes
Most of the research based on post-World War II data finds evidence of an increase in volatility during the 1970s, with a subsequent decline in the mid-1980s and 1990s. This is the main finding of Blanchard and Simon (2001), McConnell and Perez-Quiros (2000), Kahn, McConnell and Perez-Quiros (2002) and Stock and Watson (2002), who analyse the volatility of the US output growth rate between 1953 and 2000. Similar conclusions are reached by Backus, Kehoe and Taylor (1992) and Dalsgaard, Elmeskov, and Park (2000) who investigate thirteen and 25 OECD countries, respectively, from 1960 to 2000, and Barrell and Mitchell (2003), who focus on the US, the UK, France and Germany since 1970.
Papers emphasising a longer-term historical perspective are generally less positive regarding the decline of output volatility. Although most of these papers conclude that during the post-World War II period volatility has been decreasing, the levels of post-World War II output fluctuations are found to be analogous to those observed during the Gold Standard, and not substantially lower. …