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Case Study: The Great Moderation, Dead or Alive? Case Study

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Updated: Jan 15th, 2022

Application of tools to create value in a market economy

Application of analytical tools in a market economy has led to the realization that numerous benefits can result from reduced macroeconomic volatility. “Lower volatility of inflation improves market functioning, makes economic planning easier, and reduces the resources devoted to hedging inflation risks” (McConnell & Perez-Quiros, 2002, p. 12). In addition, “Lower volatility of output tends to imply more stable employment and a reduction in the extent of economic uncertainty confronting households and firms” (McConnell & Perez-Quiros, 2002, p. 23). Presently, recessions have become less severe and less frequent, hence a cutback in output volatility.

Nevertheless, it can be argued that there is a potential for such a divergence because individual firms’ performance is basically pegged on non-aggregate conditions such as firm-specific factors. For example, greater firm’s competition is likely to result from more competition which leads to tremendous consequences. However, “one firm’s gains are another firm’s losses” (McConnell & Perez-Quiros, 2002, p. 26). As such, there is little effect on volatility of aggregate production as a result of higher competition, “Firm specific-factors may therefore increase firm volatility without affecting aggregate volatility” (McConnell & Perez-Quiros, 2002, p. 26).

Market volatility in the U.S. is essentially explained by a scenario whereby “while the aggregate economy has become more stable, on average, the profits, sales and employment of individual publicly-traded companies have become more volatile” (Blanchard & Simon, 2001, p. 30). As the profits of big company have become less predictable, the schemes that relate wage level on performance of the firms have heightened the earnings unpredictability. Furthermore, workers compensation has been pegged on firm performance since around 1980. The increased volatility of wages by the U.S. workers for the last 3 decades can be explained by such accounts. The shock that hit the economy can, as such, be attributed to the economic volatility which causes great ripple on GDP of nations. For instance, “ an increase in oil prices may reduce the incentives of firms to invest in new capital, and reduced investment will lead to a decline in GDP” (McConnell & Perez-Quiros, 2002, p. 29).

Nature and structure of global economic markets

Fast economic globalization has heighted the spread and incidence of economic crisis by resulting into ripple effect. Consequently, this has exposed “the fragility of our financial system and it is becoming increasingly clear that the effects of the initial sub-prime crisis are spreading across other global markets into the real economy” (McConnell & Perez-Quiros, 2002, p. 36). Incidentally, the entire historical global financial crises are interrelated. Not a single market is immune to this global scenario. To mitigate the effects of these developments, “a clear, concrete, coordinated policies at regional and national level are required, besides building a more stable regulatory framework for the future” (Blanchard & Simon, 2001, p. 30).

The last wave of globalization movement corresponds with the great globalization moderation. The increased exchange of goods and services internationally makes it possible for countries to cushion themselves against possible shocks, and hence experiencing reduced production volatility. For instance, “if hurricane tends to destroy the tomato crop at home, the tomato soup industry can import tomatoes from overseas and reduce the impact of the hurricane.” (Blanchard & Simon, 2001, p. 32).

Globalization of markets also comes with its own shortcomings, for instance because it fails to account for the reducing productivity growth unpredictability. Large fluctuations in a globalised economy can possibly result from growth in productivity. However, the significance of the reduction in production volatility since 1984 can be compared with reduction in output growth. Additionally, relationship between the two is somewhat natural (Taylor, 1993).

Ethical implications involved in economic decisions

Issues of ethics in economic decisions are very critical, during formulation of economic policies. However, ethical efforts may face obstacles due to self-interest on the part of the involved parties who are willing to risk the wellbeing of the population for the sake of their own interests. It is generally considered to be the moral responsibility of governments to implement economic policies which observe ethical considerations. If matters are not examined carefully and ethically, millions of people can as a result become victims of poor economic conditions. Nonetheless, before economic decisions are undertaken, ethicist should examine the proposed decision and its probable consequence.

To achieve economic stability and avoid unethical practices, governments use the central bank to provide remedial measures to economic imbalances. For example, “many central banks set a target for a reference interest rate and affect the money supply through actions to achieve that target” (Taylor, 1993, p.56). Economic conditions determine the interest target that is set by the central banks. Some of the factors considered include inflation and output. Research by Taylor (1993) has revealed that “placing a positive eight on both the price level and real output in the interests-rate rule is preferable in most countries” (p.63). These actions are ethical as they are aimed at improving the well-being of the citizens.

The role and tools of the federal government in managing business cycles

The debate on the role of the federal government in managing business cycles is raging years on end. The extent to which the federal government should use fiscal policies as a way of stabilizing the economy has both advantages and disadvantages. The government role can have consequence on the volatility of output, which has mixed effects on the economy. For example, the amount of taxes levied by the government affects the level of disposable income, hence reducing the consumption level. “Automatic changes in government revenues in response to output fluctuations help smoothing business cycles through the traditional demand multiplier” (Taylor, 1993, p.71). In addition, interventions by the federal government (based on alteration caused by higher taxes) destabilize the employment state, hence resulting in an increase in labor supply elasticity.

The federal government affects the volatility of the market through making of macroeconomic policy adjustments through fiscal and monetary policies. The causes of the great modernization are actually partly attributable to the aforementioned federal government interventions, in addition to complexities of financial markets. The federal government has been reported as maintaining a narrow inflation range; which has resulted into accommodation of more shocks to the economy. As a result, “this has lowering the interest rate more when inflation slowed and raising it more when they accelerated” (Taylor, 1993, p.58). Ideally, such a policy may culminate into less consequence on GDP volatility. Apparently, focusing monetary policies on short term interest rates is a path that many countries have followed, and as a result failing to “prevent both booms and busts in real economic activity and inflation resulting from excesses in financial Markets” (Taylor, 1993, p.63). The U.S for the last couple of decades has fallen play of this view, following the evolution of bank liabilities.

References

  1. Blanchard, O., & Simon, J. (2001). The Long and Large Decline in U.S. Output Volatility. Brookings Papers on Economic Activity, 1, 135-64
  2. McConnell, P., & Perez-Quiros, M. (2002). Output Fluctuations in the United States: What has changed since the Early 1980’s. American Economic Review, 90(5), 1464– 1476
  3. Taylor, J. (1993). Discretion vs. Policy rules in Practice. Carnegie-Rochester Conference Series on Public Policy, 39, 195-214
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