RDP 2005-08: Declining Output Volatility: What Role for Structural Change? 5. Conclusions

The decline in output volatility in a number of countries over the past few decades has been well-documented, though less agreement has been reached about the causes of this decline. In this paper we take an atheoretical approach to explain the general decline in output volatility across 20 OECD countries using various indicators of structural reform, including in the areas of monetary and fiscal policies, as well as in product and labour markets. We suggest that reforms in product and labour markets can reduce volatility of aggregate output by encouraging productive resources to shift more readily in response to differential shocks across firms and sectors.

In contrast to other studies, we include direct measures of product market regulations and monetary policy regimes as explanators for output volatility. We find that less product market regulation and stricter monetary policy regimes have played a role in reducing output volatility, with our estimates robust to a number of alternative specifications. We attempt to control for a possible trend in common (unexplained) innovations to output volatility, including a possible decline in the magnitude of global shocks. The coefficient estimates on the product market regulations and the monetary policy regime variables are robust to controlling for trends in common innovations by including a linear time trend, a ‘good luck’ dummy variable, or by examining the behaviour of output volatility across countries relative to the US. These coefficient estimates are less robust to the inclusion of time dummies. This possibly reflects the fact that there is not a lot of variation across countries (other than for the US) for these explanatory variables. However, in the presence of time dummies, indirect measures of labour market regulations (days lost to labour disputes) and of monetary policy effectiveness (inflation volatility) are significant, reflecting greater cross-country variation in their behaviour over time. Other indirect measures of market reforms, such as trade openness and credit to GDP, are generally not statistically significant explanators of output volatility.

Studies that have used structural models to identify various demand and supply shocks find that most of the decline in output volatility is due to a decline in the magnitude of shocks, with a limited role for structural reforms and monetary policy. In comparison, our atheoretical approach accounts for the possibility that smaller shocks may themselves be the result of structural changes. The finding of a significant role for increased efficacy of monetary policy and less regulated markets in explaining the trend decline in output volatility across a wide range of developed economies has an important implication for future output volatility. Namely, while any decline in global shocks that has been driven solely by good fortune cannot (by definition) continue indefinitely, the benefit of significant structural reforms is likely to limit the extent of any future rise in output volatility.