I show that the defining features of the Great Moderation were a shift in output volatility toward medium-term fluctuations and a shift in the origin of those fluctuations from the real to the financial sector. I uncover a Granger-causal relationship whereby financial cycles attenuate short-term business cycle fluctuations while simultaneously amplifying longer-term fluctuations. As a result, financial shocks systematically drive medium-term output fluctuations, whereas real shocks drive short-term output fluctuations. I use these results to argue that the Great Moderation and Great Recession both resulted from the same economic forces. On the theoretical front, I show that long-run risk is a critical ingredient of DSGE models with financial sectors that seek to replicate these shifts. Finally, I use this DSGE model to refine the “good luck” and “good policy” hypotheses of the Great Moderation.
