Working Paper Series THE MACROECONOAAIC EFFECTS OF OIL PRICE SHOCKS : WHY ARE THE 2000 s SO DIFFERENT FROM THE 1 970 s ?

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. * We are grateful for helpful comments and suggestions to Julio Rotemberg, John Parsons, Lutz Kilian, Jose de Gregorio, Gauti Eggertson and participants at NBER ME Meeting, the NBER Conference on "International Dimensions of Monetary Policy", and seminars at CREI-UPF. We thank Davide Debortoli for excellent research assistance, and the NSF and the Banque de France Foundation for financial Eissistance. This version updates an earlier (September 2007) version, using data up to 2007:3. t MIT and NBER. * CREI, UPF and NBER. Introduction Since the 1970s, and at least until recently, macroeconomists have viewed changes in the price of oil as 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 industriahzed 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 signiflcant 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, both 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 poHcy can play in order to mitigate their adverse effects. One plausible hypothesis is that the eS'ects of the increase in the price of oil proper have been similar across episodes, but have coincided in time with large shocks of a very different nature (e.g. large rises in other commodity prices in the 1970s, high productivity growth and world demand in the 2000s) . That coincidence could significantly distort any assessment of the 1. Most undergraduate textbooks make an unambiguous connection between the two oil price hikes of 1973-1974 and 1979-1980 and the period of stagflation that ensued. See e.g. Mankiw (2007, p. 274). impact of oil shocks based on a simple observation of the movements in aggregate variables around each episode. In order to evaluate' this hypothesis one must isolate the component of macroeconomic fluctuations associated with exogenous changes in the price of oil. To do so, we identify and estimate the effects of an oil price shock using structural VAR techniques. We report and compare estimates for different sample periods and discuss how they have changed over time. We follow two alternative approaches. The first one is based on a large VAR, and allows for a break in the sample in the mid 1980s. The second approach is based on rolling bivariate VARs, including the price of oil and one other variable at a time. The latter approach allows for a gradual change in the estimated effects of oil price shocks, without imposing a discrete break in a single period. Two conclusions clearlj' 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 findings are summarized graphically in Figure 1 (we postpone a description of the underlying assumptions to Section 3). The left-hand graph shows the responses of U.S. (log) GDP and the (log) CPI to a 10 percent increase in the price of oil, estimated using pre-1984 data. The right-hand graph displays the corresponding responses, based on post-1984 data. As the Figure makes clear, the response of both variables has become more muted in the more recent period. As we show below, that pattern can also be observed for other variables (prices and quantities) and many (though not all) other countries considered. In sum, the 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. US Impulse response to