Financial Frictions, Financial Shocks, and Aggregate Volatility

I revisit the Great Inflation and the Great Moderation for nominal and real variables. I document a dichotomy in the evolution of the cyclical volatility of financial variables since the mid-1980s. While financial price variables are smoother during the Great Moderation, financial quantity measures experience an immoderation. A model with financial frictions and financial shocks allowing for structural breaks in the size of shocks and the institutional framework is estimated. The paper shows that (i) while the Great Inflation was driven by bad luck, the Great Moderation is mostly due to better institutions; (ii) the slowdown in financial price volatilities is driven by an easier access to credit, while a higher exposure to financial risk determines the immoderation of financial quantity measures; and (iii) financial shocks arise as relevant drivers of US business cycle fluctuations. JEL: E32, E44, C11, C13