Monetary Policy, Oil Shocks, and TFP: Accounting for the Decline in U.S. Volatility

A previous version of this working paper was published in 2003.

The proximate causes of the increased stability and their relative importance remain unsettled, but the sharpness of the volatility decline and its timing has led authors such as Taylor (2000) to argue that a sudden shift in monetary policy is a prime candidate. The authors assess this claim using a calibrated stochastic dynamic general equilibrium model to quantify the contribution of monetary policy and exogenous shocks to the postwar volatility pattern for U.S. output. Their principal finding is that the change in monetary policy played a relatively small role in the postwar volatility decline, accounting for 10 to 15 percent of the drop in real output volatility. The model attributes most of the output volatility decline to smaller TFP shocks: oil shocks end up increasing volatility in the post-1984 period relative to the pre-1979 period. Negative oil shocks do lead to significant downturns in real output in the model, but the pattern of exogenous shocks post-1984 is not different enough from the pre-1979 pattern to play a meaningful role in lowering output volatility.