Financial Innovations: An Alternative Explanation to the Great Moderation

This paper argues that the sustained decline in the volatilities of real variables over the past two decades in the United States can be partially attributed to financial innovations in the late-1970s. Prior to these changes, households faced significant transaction costs, which deterred them from fully adjusting their portfolios every period. However, advances in information technology and financial deregulation decreased transaction costs, facilitating portfolio re-balancing and increasing household participation. Higher household participation decreases the volatility of asset prices, which in turn contributes to smoothing investment and consumption. Changing from a portfolio sluggishness of four quarters to complete flexibility can account for almost 25 percent of the decline in the volatilities of output, consumption, and investment.