What caused the decline in U.S. business cycle volatility?

This paper investigates the sources of the widely noticed reduction in the volatility of American business cycles since the mid 1980s. Our analysis of reduced volatility emphasizes the sharp decline in the standard deviation of changes in real GDP, of the output gap, and of the inflation rate. The primary results of the paper are based on a small three-equation macro model that includes equations for the inflation rate, the nominal Federal Funds rate, and the change in the output gap. The development and analysis of the model goes beyond the previous literature in two directions. First, instead of quantifying the role of shocks-in-general, it decomposes the effect of shocks between a specific set of supply shock variables in the model's inflation equation, and the error term in the output gap equation that is interpreted as representing "IS" shifts or "demand shocks". It concludes that the reduced variance of shocks was the dominant source of reduced business-cycle volatility. Supply shocks accounted for 80 percent of the volatility of inflation before 1984 and demand shocks the remainder. The high level of output volatility before 1984 is accounted for roughly two-thirds by the ou