The Great Moderation and the Financial Cycle

We show that the defining features of the Great Moderation were a shift from output volatility to medium-term fluctuations and a shift in the origin of those fluctuations from the real to the financial sector. We discover a Granger-causal relationship by which financial cycles attenuate short-term business cycle fluctuations while they amplify longer-term fluctuations at the same time. As a result, financial shocks systematically drive medium-term output fluctuations whereas real shocks drive short-term output fluctuations. We use these results to argue that the Great Moderation and Great Recession both result from the same economic forces. On the theoretical front, we show that long-run risk is a critical ingredient of DSGE models with financial sectors that seek to replicate these shifts. Finally, we used this DSGE model to refine "good luck" and "good policy" hypothesis of the Great Moderation