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Oil and the Great Moderation 2007 OIL AND THE GREAT MODERATION 2007 Antón Nákov and Andrea Pescatori Documentos de Trabajo N.º 0735 OIL AND THE GREAT MODERATION OIL AND THE GREAT MODERATION Antón Nákov (*) BANCO DE ESPAÑA Andrea Pescatori FEDERAL RESERVE BANK OF CLEVELAND (*) Corresponding author. E-mail addres: We are grateful for comments to Jordi Galí, Fabio Canova, Pau Rabanal, Gabriel Perez-Quiros and seminar participants at Banco de España. Documentos de Trabajo. N.º 0735 2007 The Working Paper Series seeks to disseminate original research in economics and finance. All papers have been anonymously refereed. By publishing these papers, the Banco de España aims to contribute to economic analysis and, in particular, to knowledge of the Spanish economy and its international environment. The opinions and analyses in the Working Paper Series are the responsibility of the authors and, therefore, do not necessarily coincide with those of the Banco de España or the Eurosystem. The Banco de España disseminates its main reports and most of its publications via the INTERNET at the following website: http://www.bde.es. Reproduction for educational and non-commercial purposes is permitted provided that the source is acknowledged. © BANCO DE ESPAÑA, Madrid, 2007 ISSN: 0213-2710 (print) ISSN: 1579-8666 (on line) Depósito legal: M.48354-2007 Unidad de Publicaciones, Banco de España Abstract We assess the extent to which the great US macroeconomic stability since the mid-1980s can be accounted for by changes in oil shocks and the oil share in GDP. To do this we estimate a DSGE model with an oil-producing sector before and after 1984 and perform counterfactual simulations. We nest two popular explanations for the Great Moderation: (1) smaller (non-oil) real shocks; and (2) better monetary policy. We find that the reduced oil share accounted for as much as one-third of the inflation moderation, and 13% of the growth moderation, while smaller oil shocks accounted for 11% of the inflation moderation and 7% of the growth moderation. This notwithstanding, better monetary policy explains the bulk of the inflation moderation, while most of the growth moderation is explained by smaller TFP shocks. Keywords: Great Moderation, oil shocks, Bayesian estimation, counterfactual simulations JEL: E32, E52, Q43 )FXTWe`Y Y`eTHPI eSFe FWW Gfe `YP B@ cPHPddT`Yd dTYHP D`cWI DFc 00 hPcP acPHPIPI Gp TYHcPFdPd TY eSP acTHP `Q HcfIP `TW dfRRPdeTYR eSFe Pi`RPY`fd `TW dS`HVd hPcP cPda`YdTGWP Q`c XfHS `Q eSP a`de#hFc g`WFeTWTep `Q B@ (%7 Rc`heS dPP 'TRfcP ) 6eSPc FfeS`cd Q`fYI dTXTWFc PgTIPYHP `Q F WTYV GPehPPY `TW acTHP cTdPd FYI B@ TYsFeT`Y Fd hPWW Fd F WTYV GPehPPY `TW acTHP sfHefFeT`Yd FYI G`eS `feafe Rc`heS FYI TYsFeT`Y TY `eSPc TYIfdecTFWTqPI H`fYecTPd P)R) %FcGp #fcGTIRP FYI )FccTd`Y ) ASP cPWPgFYHP `Q `TW Fd F d`fcHP `Q XFHc`PH`Y`XTH sfHefFeT`Yd hFd PdeFG# WTdSPI Fd H`YgPYeT`YFW hTdI`X Fe WPFde fYeTW )``VPc a`TYePI e` F GcPFV TY eSP `TW acTHPw(%7 cPWFeT`YdSTa FYI )``VPc Q`fYI F aFcFWWPW GcPFV TY eSP `TW acTHPwTYsFeT`Y cPWFeT`YdSTa Fc`fYI ) ASTd GcPFV IFeP c`fRSWp H`TYHTIPd hTeS Gfe acPHPIPd eSP GPRTYYTYR `Q F aPcT`I `Q cPXFcVFGWP XFHc`PH`Y`XTH deFGTWTep IfGGPI Gp d`XP PH`Y`XTded Fd eSP u(cPFe 4`IPcFeT`Yv FYI cPsPHePI TY F dSFca IPHWTYP TY eSP g`WFeTWTep FYI d`XPeTXPd eSP aPcdTdePYHP `Q VPp XFHc` gFcTFGWPd TY F YfXGPc `Q TYIfdecTFWTqPI PH`Y`XTPd TYHWfITYReSP B@ dPP AFGWP FYI rRfcPd FYI ) @TYHP PgTIPYHP dfRRPded eSFe eSP X`IPcFeT`Y Td dacPFI FHc`dd F YfXGPc `Q H`fYecTPd FYI `TW dfaaWp dS`HVd FcP WTVPWp e` FyPHe XFYp `TW#TXa`ceTYRH`fYecTPd TY F dTXTWFc hFp F cPIfHeT`Y TY `TW dPHe`c g`WFeTWTep `c F IFXaPYTYR`Q eSP ecFYdXTddT`Y `Q eSFe g`WFeTWTep e` eSP cPde `Q eSP h`cWI PH`Y`Xp Td F YFefcFW HFYITIFeP aPcSFad h`cVTYRFW`YRdTIP`eSPc QFHe`cd Q`c PiaWFTYTYReSP cTdP `Q XFHc`PH`Y`XTH deFGTWTep TY eSP FIgFYHPI h`cWI) 6YP a`ddTGTWTep Td eSFe `TW dfaaWp dS`HVd SFgP dTXaWp GPH`XP dXFWWPc `c WPdd QcPbfPYe TY eSP aPcT`I FQePc ! Fe eSP dFXP eTXP ITgPcdTrHFeT`Y e`hFcId WPdd `TW#TYePYdTgP dPHe`cd FYI TYHcPFdPI PYPcRp PxHTPYHp XFp cPIfHP eSP dSFcP `Q `TW TY (%7 FYI eSfd ITXTYTdS eSP TXa`ceFYHP `Q `TW dfaaWp dS`HVd) DP FddPd eSP PiePYe e` hSTHS eSP XFHc`PH`Y`XTH X`IPcFeT`Y TY eSP B@ HFY GP FHH`fYePI Q`c Gp HSFYRPd TY `TW dS`HVd FYI eSP `TW dSFcP Gp aPcQ`cXTYR H`fYePcQFHefFW dTXfWFeT`Yd GFdPI `Y #FpPdTFY PdeTXFeT`Y `Q eSP X`IPW `Q 5FV`g FYI 7PdHFe`cT Q`c eSP aPcT`Id acP# FYI a`de#) 0Y I`TYRd` hP YPde eh` a`afWFc PiaWFYFeT`Yd Q`c eSP (cPFe 4`IPcFeT`Y uR``I WfHVv TY eSP Q`cX `Q F dSTQe TY eSP ITdecTGfeT`Y `Q A'7 FYI `eSPc Y`Y#`TW cPFW dS`HVd Fd HWFTXPI Q`c PiFXaWP Gp "SXPI 3PgTY FYI DTWd`Y FYI @e`HV FYI DFed`Y ! FYI FY TXac`gPXPYe TY eSP H`YIfHe `Q X`YPeFcp a`WTHp Fd FcRfPI @aPHTrHFWWp )``VPc Q`fYI eSFe eh` hTIPWp fdPI ecFYdQ`cXFeT`Yd `Q eSP `TW acTHP I` Y`e (cFYRPc HFfdP `feafe TY eSP a`de# aPcT`I hSTWP )``VPc TIPYeTrPI F decfHefcFW GcPFV TY H`cP B@ TYsFeT`Y 7STWWTad HfcgPd dfHS eSFe `TW acTHPd H`YecTGfePI dfGdeFYeTFWWp e` H`cP TYsFeT`Y GPQ`cP Gfe dTYHP eSFe eTXP eSP aFdd#eSc`fRS SFd GPPY YPRWTRTGWP) ASP u(cPFe 4`IPcFeT`Yv hFd Y`eTHPI Gp 2TX FYI 5PWd`Y FYI 4H$`YYPW FYI 7PcPq#8fTc`d FYI Ted GPRTYYTYR Td fdfFWWp IFePI Fc`fYI ) $PHHSPeeT Pe) FW) rYI PgTIPYHP `Q X`IPcFeT`Y TY `fe `Q TYIfdecTFWTqPI H`fYecTPd FYI @e`HV FYI DFed`Y cPa`ce dTXTWFc PgTIPYHP Q`c `Q eSP (# H`fYecTPd! `Y eSP `eSPc SFYI dPP $FY`gF Pe) FW) Q`c PgTIPYHP eSFe eSP X`IPcFeT`Y SFd GPPY X`cP `Q FY "YRW`#@Fi`Y aSPY`XPY`Y) BANCO DE ESPAÑA 9 DOCUMENTO DE TRABAJO N.º 0735 by Clarida, Gali and Gertler (2000) and Boivin and Giannoni (2003).4 We find that oil played a non-trivial role in the moderation. In particular, the reduction of the oil share alone can explain around one third of the inflation moderation, and 13% of the GDP growth moderation. In turn, oil sector shocks alone can account for 7% of the growth moderation and 11% of the inflation moderation. Yet, the dominant role was played by non-oil shocks and by mon- etary policy. In particular, smaller TFP shocks account for two-thirds of GDP growth moderation, while better monetary policy alone can explain two-thirds of the inflation moderation. Related to this, we find evidence that the inflation-output gap tradeoff has become more benign after 1984 due to the smaller share of oil in GDP. More generally, oil sector shocks have become less important for US macroeconomic fluctuations relative to US-originating shocks to TFP, preferences and policy. The rest of the paper is organized as follows. The next section puts our work in the context of the related literature; section 3 presents the stylized volatility facts; section 4 sketches a log-linearized version of the oil pricing model of Nakov and Pescatori (2007) and illustrates how different factors could cause moderation; section 5 covers the data and estimation methodology; section 6 describes our priors and the estimation results; section 7 contains counterfactual analysis decomposing the volatility moderation into contributions by each factor, and discusses the implied changes in the Phillips curve; section 8 relates our results to those of the literature and the last section concludes. 2 Related Literature Our paper is related to several distinct lines of research. One is the empirical literature on the link between oil and the macroeconomy starting with Darby (1982) and Hamilton (1983). Bernanke, Gertler and Watson (1997) challenged the finding of Hamilton (1983), documenting that essentially all U.S. recessions in the postwar period were preceded by both oil price increases as well as a tightening of monetary policy. Using a modified VAR methodology they found that the systematic monetary policy response to inflation (presumably caused by oil price increases) accounted for the bulk of the depressing effects of oil price shocks on the real economy. What is more, Barsky and Killian (2001) and Killian (2005) argued that even the major oil price increases in the 1970s were not an essential part of the mechanism that generated stagflation, and that the latter is attributable instead to monetary factors. Unlike these studies, our analysis is based on a structural model featuring optimal oil price setting, estimated with Bayesian methods. This allows us to disentangle the contribution of policy from the effects of oil shocks and the oil share without running into the Lucas critique. 4 We do not control for other possible explanations involving structural changes in private sector behavior, such as better inventory management (McConnell and Perez-Quiros, 2000), or financial innovation (Dynan, Elmendorf and Sichel, 2005). 3 BANCO DE ESPAÑA 10 DOCUMENTO DE TRABAJO N.º 0735 Another strand of research deals with theoretical models of the link between oil and the macroeconomy. Some of the more recent contributions include Kim and Loungani (1992), Rotemberg and Woodford (1996), Finn (1995, 2000), Leduc and Sill (2004), and Carlstrom and Fuerst (2005). While these studies differ in the way oil is employed in the economy (as a consumption good, as a standard productive input, or as a factor linked to capital utilization), and hence in the implications of oil shocks, they all share the assumption that the oil price (or oil supply) is exogenous, and hence unrelated to any economic fundamentals.
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