Abstract:
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We investigate the hypothesis that macroeconomic fluctuations are primitively the
results of many microeconomic shocks, and show that it has significant explanatory
power for the evolution of macroeconomic volatility. We define fundamental volatility
as the volatility that would arise from an economy made entirely of idiosyncratic microeconomic
shocks, occurring primitively at the level of sectors or firms. In its empirical
construction, motivated by a simple model, the sales share of different sectors vary over
time (in a way we directly measure), while the volatility of those sectors remains constant.
We find that fundamental volatility accounts for the swings in macroeconomic
volatility in the US and the other major world economies in the past half century. It
accounts for the great moderation and its undoing. Controlling for our measure of
fundamental volatility, there is no break in output volatility. The initial great moderation
is due to a decreasing share of manufacturing between 1975 and 1985. The recent
rise of macroeconomic volatility is due to the increase of the size of the financial sector.
We provide a model to think quantitatively about the large comovement generated by
idiosyncratic shocks. As the origin of aggregate shocks can be traced to identifiable
microeconomic shocks, we may better understand the origins of aggregate fluctuations. |