Financial Frictions, Financial Shocks, and Aggregate Volatility

Abstract

I revisit the Great Inflation and the Great Moderation for nominal and real variables. I document that while financial price variables follow such a pattern; financial quantity variables experience a continuous 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 while the Great Inflation was driven by bad luck, the Great Moderation is mostly due to better financial institutions. Financial shocks arise as relevant drivers of US business cycle fluctuations.