The Great Diversification and Its Undoing

Recognition Program

Authors: Vasco M. Carvalho and Xavier Gabaix

American Economic Review, Vol. 103, No 5, 1697--1727, January, 2013

We investigate the hypothesis that macroeconomic fluctuations are primitively the results of many microeconomic shocks. We define fundamental volatility as the volatility that would arise from an economy made entirely of idiosyncratic sectoral or firm-level shocks. Fundamental volatility accounts for the swings in macroeconomic volatility in the major world economies in the past half-century. It accounts for the "great moderation" and its undoing. The initial great moderation is due to a decreasing share of manufacturing between 1975 and 1985. The recent rise of macroeconomic volatility is chiefly due to the growth of the financial sector.

This paper originally appeared as Barcelona GSE Working Paper 422
This paper is acknowledged by the Barcelona GSE Research Recognition Program