Impact of Great moderation period

rates from FTS shock is cut short by a simultaneous response of the Monetary policy, or a cut in nominal rates. It signifies that FTS shocks are co-incidental with cuts in policy rates, which further strengthens our initial hypothesis of the FTS shock being a pre-cursor of worsening economic climate.

By removing the restriction on response of Real rates in Identification Strategy 3, we can also remove the constraints on contemporaneous changes in monetary policy in response to FTS shocks. This leaves the interest rate policy some scope to be pre-emptive. Therefore the cuts in real rates in this strategy occur earlier compared to rate cuts in strategy 1 and 2. Through this, we witness that the delay in the response of TFP to FTS shocks is also shortened. Evidently, the TFP begins to decline after 5 periods, whereas it declines 8-10 periods after FTS shocks in identification strategy 1. Hours, output, consumption, and investment all exhibit a faster decline (or a shorter slump) and reach the minimum around the same time, i.e., 5 periods after the shock, when total factor productivity growth becomes less than zero. The main result from different identification strategies reinforces the conviction of results of identification strategy 1, which is that the innovations in Price of Risk (Bond minus Equity prices) predate a general economic slump, which in around 8-10 quarters also leads to an eventual decline in TFP.

Next, we look to address the possible criticism that the chosen data period in our benchmark configuration period of 1983:Q1 to 2019:Q3 is heavily influenced by the increase in the supply of safe assets around the world since the global financial crisis and by the impact of the crisis itself. This criticism is addressed by curtailing the analysis to the pre-crisis period of 1983:Q1 to 2007:Q2, which is also the Great Moderation period. We also consider the sensitivity of the results to the pre-Great Moderation period of 1954:Q3 to 1978:Q4, intending to understand the influence of great moderation on the strength of Flight to Safety shocks.

6.2 Impact of Great moderation period

From the mid-80s to global financial crises, the Great moderation period represents a period in the macroeconomic history of developed economies when the incidence and volatility of business cycle fluctuations were significantly reduced from the decades that preceded it, 1954 to 1978. Structural developments in public policy and the Federal reserve’s policy commitment and communication strategy were

influential in bringing out this change in business cycle incidence and volatility during the Great Moderation period. It is argued that economic agents were better able to form expectations about future economic and policy uncertainty during great moderation than in the decades that preceded it.

The results of this empirical study show us that FTS shocks breed in pes-simism about the general economic climate that predates an eventual decline in future TFP. One of the reasons this is possible is if FTS shocks signal households to expect future TFP and economic growth to be weaker. If these expectations are well-formed, then in line with the Great moderation literature, they must be significantly well-formed in the Great moderation era 1983-2007 than in the volatile era 1954-1978. Figure 17 on page73 shows the median impulse responses to FTS shocks for business cycles variables of macroeconomic variables of interest for the pre-Great moderation period (1954-1978) in dashes, and the Great Mod-eration period (1985-2007) in squared line. This figure also compares these two periods with the benchmark period (1985-2019) median response given in a solid line. The shaded area depicts 68% confidence bands for the benchmark period responses.

It is clear from the results that the FTS shock has a limited impact during the pre-Great moderation period (dashes in Figure17). This suggests that FTS shocks have been more critical in the Great moderation period. Due to the available technology, structural policy changes and low inflation in this period, it was easier to form expectations about the future TFP growth. Moreover, through improved trading opportunities and increased participation from retail investors, there has been an increase in availability and awareness about risky and safe assets in the Great moderation period as compared to the earlier period. The impact of the global financial crisis is also visible through the comparison of Great Moderation (squares) and the benchmark period (solid) results in fig. 17. The inclusion of post-Global financial crisis data accentuates the responses in unemployment and residential investments. What stands out most from the result is that during the Great Moderation, the response of investment, hours, real rates, utilization-adjusted total factor productivity is similar in scale and scope as predicted by the benchmark model. It reinstates our conviction in the results that FTS shocks generate business cycle fluctuations.

Thus from the various identification strategies, periods, and business cycle variables employed in this empirical study, we can confirm that the identified FTS shocks of the Price of risk (Bond minus Equity price) series are linked to

6 . 2 I m pac t o f G r e at m o d e r at i o n p e r i o d 73

Figure 17: Sensitivity of impulse responses to different time periods

0 10 20 30

Notes: Sensitivity of impulse responses to FTS shocks during Benchmark period 1983:Q1 to 2019:Q3 (Solid) with responses from Pre-Great moderation period 1954:Q3 to 1978:Q4 (Dashes) and Great Moderation period 1983:Q1 to 2007:Q2 (Squares). 68%

confidence band of Benchmark period are shaded. Y-axis label is percentage points and X-axis label is Time (in quarters) horizon after the shock. ‘Cons (NDur+Svc)’

is Consumption of Non-durable goods and Services. ‘Res’ is residential, ‘Non-Res’

is non-residential, and ‘Rel.Price of Inv’ is Relative price of investment in terms of consumption.

an increase in investors’ risk aversion. They enforce a chilling effect on economic activity and predate a decline in total factor productivity. The results reinforce our initial contention for undertaking this empirical study, which was that FTS shocks have an immediate and long-term negative impact on economic activity esp.

Investments. The delayed response of TFP to FTS shocks brings to light the two channels through which FTS impacts the business cycles. Either FTS shock is an over-correction to a speculative bet gone wrong. Or FTS is grounded in rational expectations and represents a risk-aversion shock that induces a re-allocation of capital to safer assets, usually less productive. This increase in pessimism or fear of risk in a sufficient number of agents leads to an imminent long-term decline in economic activity. It is neither the objective nor the scope of this study to decide which of the two expectations channel is more crucial. However, the large and varied set of data included in this empirical exercise and the different assumptions imposed through identification strategies incline us towards the latter.