Olivier Blanchard and Jordi Gali: The Macroeconomic Effects of Oil Shocks. Why are the 2000s So Different from the 1970s?

Why did the economy respond differently to oil price shocks in the 2000s as compared to the 1970s?:

The Macroeconomic Effects of Oil Shocks. Why are the 2000s So Different from the 1970s?, by Olivier J. Blanchard and Jordi Gali, NBER WP 13368, September 2007 [open link]: Abstract We characterize the macroeconomic performance of a set of industrialized economies in the aftermath of the oil price shocks of the 1970s and of the last decade, focusing on the differences across episodes. We examine four different hypotheses for the mild effects on inflation and economic activity of the recent increase in the price of oil: (a) good luck (i.e. lack of concurrent adverse shocks), (b) smaller share of oil in production, (c) more flexible labor markets, and (d) improvements in monetary policy. We conclude that all four have played an important role.

Introduction Since the 1970s, and at least until recently, macroeconomists have viewed changes in the price of oil as an important source of economic fluctuations, as well as a paradigm of a global shock, likely to affect many economies simultaneously. Such a perception is largely due to the two episodes of low growth, high unemployment, and high inflation that characterized most industrialized economies in the mid and late 1970s. Conventional accounts of those episodes of stagflation blame them on the large increases in the price of oil triggered by the Yom Kippur war in 1973, and the Iranian revolution of 1979, respectively.

The events of the past decade, however, seem to call into question the relevance of oil price changes as a significant source of economic fluctuations. The reason: Since the late 1990s, the global economy has experienced two oil shocks of sign and magnitude comparable to those of the 1970s but, in contrast with the latter episodes, GDP growth and inflation have remained relatively stable in much of the industrialized world.

Our goal in this paper is to shed light on the nature of the apparent changes in the macroeconomic effects of oil shocks, as well as on some of its possible causes. Disentangling the factors behind those changes is obviously key to assessing the extent to which the episodes of stagflation of the 1970s can reoccur in response to future oils shocks and, if so, to understanding the role that monetary policy can play in order to mitigate their adverse effects. ...

Two conclusions clearly emerge from this analysis: First, there were indeed other adverse shocks at work in the 1970s; the price of oil explains only part of the stagflation episodes of the 1970s. Second, and importantly, the effects of a given change in the price of oil have changed substantially over time. Our estimates point to much larger effects of oil price shocks on inflation and activity in the early part of the sample, i.e. the one that includes the two oil shock episodes of the 1970s.

Our basic empirical ... evidence suggests that economies face an improved trade-off in the more recent period, in the face of oil price shocks of a similar magnitude.

We then focus on the potential explanations... We consider three hypotheses, not mutually exclusive:

First, real wage rigidities may have decreased over time. The presence of real wage rigidities generates a tradeoff between stabilization of inflation and stabilization of the output gap. As a result, and in response to an adverse supply shock and for a given money rule, inflation will generally rise more and output will decline more, the slower real wages adjust. A trend towards more flexible labor markets, including more flexible wages, could thus explain the smaller impact of the more recent oil shocks.

Second, changes in the way monetary policy is conducted may be responsible for the differential response of the economy to the oil shocks. In particular, the stronger commitment by central banks to maintaining a low and stable rate of inflation, reflected in the widespread adoption of more or less explicit inflation targeting strategies, may have led to an improvement in the policy tradeoff that make it possible to have a smaller impact of a given oil price increase on both inflation and output simultaneously.

Third, the share of oil in the economy may have declined sufficiently since the 1970s to account for the decrease in the effects of its price changes. Under that hypothesis, changes in the price of oil have increasingly turned into a sideshow, with no significant macroeconomic effects (not unlike fluctuations in the price of caviar).

To assess the merits of the different hypotheses we proceed in two steps. First, we develop a simple version of the new-Keynesian model where (imported) oil is both consumed by households and used as a production input by firms. The model allows us to examine how the economy's response to an exogenous change in the price of oil is affected by the degree of real wage rigidities, the nature and credibility of monetary policy, and the share of oil in production and consumption. We then look for more direct evidence pointing to the relevance and quantitative importance of each of those hypotheses. We conclude that all three are likely to have played an important role in explaining the different effects of oil prices during the 1970s and during the last decade. ...