What are the possible causes and

consequences of higher oil prices on the

overall economy?

November 2007
What a daunting question! With oil prices increasing rapidly in the
recent past, it is hard not to wonder what has caused it and just
what effect it might have on the rest of the economy. Let me begin
by discussing the evolution of oil prices over time.

How have oil prices behaved in recent decades?

Figure 1 shows the history of the price of oil since the early 1950s.
The price shown is the monthly average spot price of a barrel of
West Texas intermediate crude oil, measured in U.S. dollars. The
gray bars in this and all the following figures represent recessions,
as defined by the National Bureau of Economic Research.

Figure 1. Spot Oil Price ($ Barrel)

As you can see from Figure 1, a long period of oil price stability was
interrupted in 1973. In fact, the 1970s show two distinct jumps in oil
prices: one was triggered by the Yom Kippur War in 1973, and one
was prompted by the Iranian Revolution of 1979. Since then, oil
prices have regularly displayed volatility relative to the ’50s and
’60s.

Figure 2 shows the “real” oil price, calculated by dividing the price of
oil by the GDP deflator. 1 This removes the effect of inflation and
thus gives a more accurate sense of what is happening to the price
of the commodity itself. In essence, the “real” measure allows you
to compare oil prices over time in a way that you can’t when
inflation is also part of the change in price. You can see that real oil
prices have varied a lot over time, and large fluctuations tend to be
concentrated over somewhat short periods. You can also see that
by the spring of 2008, as this posting was prepared, the real price of
oil has easily exceeded that of the late 1970s.

Figure 2. Real Oil Price

Why are oil prices rising?

It is likely that both increases in demand and fears of supply

disruptions have exerted upward pressure on oil prices.2Global
demand for oil has been increasing, outpacing any gains in oil
production and excess capacity. A large reason is that developing
nations, especially China and India, have been growing rapidly.
These economies have become increasingly industrialized and
urbanized, which has contributed to an increase in the world
demand for oil. In addition, in recent years fears of supply
disruptions have been spurred by turmoil in oil-producing countries
such as Nigeria, Venezuela, Iraq, and Iran (Brown 2006).

The breathtakingly sharp increase in the price of oil in the last half
of 2007 and first half of 2008 has led many to argue that increased
speculation in commodity markets has played a role, and indeed
there is evidence of increased activity in these markets. However,
whether speculation is playing a role in high oil prices is open to
debate (Krugman 2008). It is also useful to remember that both the
demand for and the supply of oil react sluggishly to changes in
prices in the short run, so very large changes in prices can be
required to restore equilibrium if demand should move even
modestly out of line with supply.

As far as the implications of higher oil prices, there are both

microeconomic and macroeconomic answers to that question. I will
address both of these aspects in turn.

How do high oil prices affect the economy on a “micro” level?

As a consumer, you may already understand

the microeconomic implications of higher oil prices. When observing
higher oil prices, most of us are likely to think about the price of
gasoline as well, since gasoline purchases are necessary for most
households. When gasoline prices increase, a larger share of
households’ budgets is likely to be spent on it, which leaves less to
spend on other goods and services. The same goes for businesses
whose goods must be shipped from place to place or that use fuel
as a major input (such as the airline industry). Higher oil prices tend
to make production more expensive for businesses, just as they
make it more expensive for households to do the things they
normally do.

It turns out that oil and gasoline prices are indeed very closely
related. Figure 3 plots average monthly oil prices from 1990 through
early 2008, using the spot oil price for West Texas intermediate
(right scale, thin blue line, measured in dollars per barrel) and the
U.S. retail gasoline price (left scale, thick red line, measured in
cents per gallon). The two series track each other very closely over
time: increases in oil prices are accompanied by increases in
gasoline prices. As shown in the graph, the correlation coefficient
(denoted “r”) for the two series is 0.98. Moreover, the
monthly changes in oil prices and gasoline prices (not shown) also
are very highly and positively correlated.

Figure 3. U.S. Gasoline and Oil Prices

So, when oil prices spike, you can expect gasoline prices to spike
as well, and that affects the costs faced by the vast majority of
households and businesses.

What effects do oil prices have on the “macro” economy?

I’ve just explained how oil prices affect households and businesses;
it is not a far leap to understand how oil prices affect the
macroeconomy. Oil price increases are generally thought to
increase inflation and reduce economic growth. In terms of inflation,
oil prices directly affect the prices of goods made with petroleum
products. As mentioned above, oil prices indirectly affect costs
such as transportation, manufacturing, and heating. The increase
in these costs can in turn affect the prices of a variety of goods and
services, as producers may pass production costs on to consumers.
The extent to which oil price increases lead to consumption price
increases depends on how important oil is for the production of a
given type of good or service.
Oil price increases can also stifle the growth of the economy
through their effect on the supply and demand for goods other than
oil. Increases in oil prices can depress the supply of other goods
because they increase the costs of producing them. In economics
terminology, high oil prices can shift up the supply curve for the
goods and services for which oil is an input.

High oil prices also can reduce demand for other goods because
they reduce wealth, as well as induce uncertainty about the future
(Sill 2007). One way to analyze the effects of higher oil prices is to
think about the higher prices as a tax on consumers (Fernald and
Trehan 2005). The simplest example occurs in the case of imported
oil. The extra payment that U.S. consumers make to foreign oil
producers can now no longer be spent on other kinds of
consumption goods.3

Despite these effects on supply and demand, the correlation

between oil price increases and economic downturns in the U.S. is
not perfect. Not every sizeable oil price increase has been followed
by a recession. However, five of the last seven U.S. recessions
were preceded by considerable increases in oil prices (Sill 2007).4

Is the relationship between oil prices and the economy always

the same?

The two aforementioned large oil shocks of the 1970s were

characterized by low growth, high unemployment, and high inflation
(also often referred to as periods of stagflation). It is no wonder that
changes in oil prices have been viewed as an important source of
economic fluctuations.

However, in the past decade research has challenged this

conventional wisdom about the relationship between oil prices and
the economy. As Blanchard and Gali (2007) note, the late 1990s
and early 2000s were periods of large oil price fluctuations, which
were comparable in magnitude to the oil shocks of the 1970s.
However, these later oil shocks did not cause considerable
fluctuations in inflation (Figure 4), real GDP growth (Figure 5), or
the unemployment rate.
 Figure 4. Oil Prices and CPI Inflation

Figure 5. Oil Prices and Real GDP Growth

A caveat is in order, however, because simply observing the

movements of inflation and growth around oil shocks may be
misleading. Keep in mind that oil shocks have often coincided with
other economic shocks. In the 1970s, there were large increases in
commodity prices, which intensified the effects on inflation and
growth. On the other hand, the early 2000s were a period of high
productivity growth, which offset the effect of oil prices on inflation
and growth. Therefore, to determine whether the relationship
between oil prices and other variables has truly changed over time,
one must go beyond casual observations and appeal to
econometric analysis (which allows researchers to control for other
developments in the economy when studying the link between oil
prices and key macroeconomic variables).

Formal studies find evidence that the link between oil prices and the
macroeconomy has indeed deteriorated over time. For example,
Hooker (2002) suggests that the structural break in the relationship
between inflation and oil prices occurred at the end of 1980s.
Blanchard and Gali (2007) look at the responses of prices, wage
inflation, output, and employment to oil shocks. They too find that
the responses of all these variables to oil shocks have become
muted since the mid-1980s.

Why might the relationship between oil prices and key

macroeconomic variables have weakened?

Economists have offered some potential explanations behind the

weakening link between oil prices and inflation. Gregory
Mankiw (2007) suggests increases in energy efficiency as one
explanation. Indeed, as shown in Figure 6, energy consumption per
dollar of GDP has gone down steadily over time. This means that
energy prices matter less today than they did in the
past. Blanchard and Gali (2007) suggest additional explanations.
They find that increased flexibility in labor markets, monetary policy
improvements, and a bit of good luck (meaning the lack of
concurrent adverse shocks) have also contributed to the decline of
the impact of oil shocks on the economy.

Finally, how monetary policymakers treated the economic shocks

caused by rising oil prices also may have played a role in the
impact of the shocks on economic growth and the inflation rate.
Specifically, some have argued policymakers tended to worry more
about output than inflation during the oil shocks of 1970s and did
not adequately take into account the inflationary aspect of the oil
shocks when fashioning a policy response to them (see, for
example, Clarida, Gali, and Gertler 2000). In the case of the U.S.,
since households and firms sensed that the Fed was not going to
pay a lot of attention to inflation, they probably realized that the oil
shocks would lead to substantially higher future inflation and
adjusted their expectations accordingly. By contrast, the Fed in the
2000s is more committed to fighting inflation, the public knows it,
and the result has been that, even though headline inflation has
risen noticeably because of the direct effects of oil and commodity
shocks, core inflation and inflation expectations remain contained.

The lack of major output effects of oil price shocks since the 1970s
calls into question what role they played during the two recessions
of that period. In other words, one possible reason why oil shocks
seem to have noticeably smaller effects on output now than they did
in the 1970s is that the world has changed. Another is that the
effects of oil shocks were never as large as conventional wisdom
hold, and that the slow growth of that decade had to do with other
factors.

Figure 6. U.S. Energy Consumption

Endnotes

1. Note that there are many possible ways to measure real oil
prices, depending on which measure of inflation you use.

2. To read more about supply and demand pressures on the world

market for oil, consult the Short-Term Energy Outlook provided by
the U.S. Energy Information Administration.
3. Trade does complicate matters here, because some of the U.S.
consumption expenditures would have been made on imports, so
that doesn’t affect the domestic economy. Second, oil producers
will use some of their income to buy goods from the U.S., so that
income is not lost to the U.S. Even so, there is a loss here,
because they can buy more U.S. exports for each barrel of oil.

4. At the time this response was written, the NBER had not made
an official pronouncement on whether the economy had entered a
recession in early 2008.

References

Blanchard, Olivier, and Jordi Gali. 2007. “The Macroeconomic

Effects of Oil Shocks: Why Are the 2000s So Different from
1970s.” NBER Working Paper No. 13368.

Brown, Stephen P.S. 2006. “Making Sense of High Oil Prices: A

Conversation with Stephen P.A. Brown.” FRB Dallas Southern
Economy, Issue 4, July/August, pp. 8-9.

Clarida, Richard, Jordi Gali, and Mark Gertler. 2000. "Monetary

Policy Rules and Macroeconomic Stability: Evidence and Some
Theory." Quarterly Journal of Economics, pp. 147-180.

Fernald, John, and Bharat Trehan. 2005. “Why Hasn’t the Jump in
Oil Prices Led to a Recession?” FRBSF Economic Letter 2005-31.

Hooker, Mark. 2002. “Are Oil Shocks Inflationary? Asymmetric

and Nonlinear Specifications versus Changes in Regime.” Journal
of Money Credit and Banking, Vol. 34, Issue 2, pp. 540-561.

Krugman, Paul. 2008. “Fuels on the Hill.” New York Times, June
27, 2008.

Mankiw, Gregory. 2007. “Where Have All the Oil Shocks Gone?”

Sill, Keith. 2007. “The Macroeconomics of Oil Shocks.”

FRB Philadelphia Business Review, 2007:Q1.