Financial frictions and changing macroeconomic volatility

This paper studies the impact of changing financial frictions on the Great Moderation using an estimated, nonlinear New Keynesian model. The model features financial frictions, parameter drift, and stochastic volatility. The estimation results show that financial frictions fell during the 1980s and remained low throughout the Great Moderation. Based on counterfactual studies, the reduction in financial frictions was an important reason for the reduction in volatility observed during the Great Moderation. The results show little role for changing monetary policy or reduced shock volatility, two common explanations, in causing the Great Moderation.