On the Sources of the Great Moderation in Italy - A Time Varying VAR Approach

Abstract: The Great Moderation, a long-lasting period of reduced fluctuations in key macroeconomic variables, has attracted the attention of many scholars because of the positive outcomes associated with low volatility. The aim of these studies has mainly been to identify the ultimate source of this phenomenon. Interestingly, even though the Great Moderation has been documented to be an international phenomenon, the literature has exclusively focused on analyzing the experience of the United States. In this work, we aim at expanding our knowledge of the Great Moderation by analyzing the Italian experience, filling a research gap identified in the literature. To do so, we develop a novel time varying VAR model to implement: (i) a forecast error variance decomposition analysis; (ii) an impulse response function analysis; (iii) a counterfactual experiment. The empirical evidence provided by these exercises highlights that the Great Moderation in Italy was mostly the consequence of good luck, with better monetary policy playing a secondary role. Accordingly, we conclude that low volatility will not necessarily be the norm in the future, since an increase in the size of exogenous shocks could rapidly overturn this state.