1970 1975 1980 1985 1990 1995 2000 2005

8

6

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0

CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

The Economic Effects of Recent

Increases in Energy Prices

JULY 2006

U.S. Spending on Petroleum as a

Percentage of Gross Domestic Product
Pub. No. 2835
The Congress of the United States O Congressional Budget Office

CBO

The Economic Effects of Recent

Increases in Energy Prices

July 2006

A

PAPER
Notes

Unless otherwise indicated, all years referred to in this report are calendar years.

Many of the figures in the paper use shaded vertical bars to indicate periods of recession. A 

recession extends from the peak of a business cycle to its trough.
Preface

Since late 2003, the price of crude oil has doubled, and prices for gasoline and natural 

gas have also risen significantly. What impact have those increases had on the U.S. economy? 

This Congressional Budget Office (CBO) paper—prepared at the request of the Chairman of 

the Senate Budget Committee—analyzes the short-term macroeconomic effects of the recent 

rise in energy prices as well as the likely effects over the next 10 years. The paper also evaluates 

the reasons that those effects have been smaller than might be expected on the basis of the 

U.S. economy’s response to the oil price shocks of the 1970s. In keeping with CBO’s mandate 

to provide objective, impartial analysis, this report makes no recommendations.

John Peterson of CBO’s Macroeconomic Analysis Division wrote the paper—with assistance 

from Richard Farmer, Mark Lasky, Angelo Mascaro, and Adam Weber—under the supervision of Robert Dennis. Bob Arnold, Douglas Hamilton, Arlene Holen, Joseph Kile, Kim 

Kowalewski, David Moore, and Thomas Woodward of CBO provided helpful comments, 

as did James Hamilton of the University of California at San Diego and Ellen HughesCromwick of the Ford Motor Company. (The assistance of external participants implies 

no responsibility for the final product, which rests solely with CBO.)

Christian Howlett edited the paper, and Christine Bogusz proofread it. Adam Weber produced the figures. Maureen Costantino designed the cover and prepared the paper for publication. Lenny Skutnik produced the printed copies, and Simone Thomas prepared the 

electronic version for CBO’s Web site (www.cbo.gov).

Donald B. Marron

Acting Director

July 2006

Contents

Summary vii

1 Developments in Oil and Natural Gas Markets Since 2003 1

Increases in Demand 1

Restrictions on Supply 1

Price Expectations for Oil 3

2 The Economic Effects of Higher Oil and Natural Gas Prices 5

The Short-Term Impact of Price Rises During the 

2004–2006 Period 5

The Impact of the Recent Energy Price Increases over the 

Next Ten Years 10

3 Why Have the Negative Effects of Recent Energy Price Increases 

Been Smaller Than Those in the 1970s? 15

Immediate Effects on Demand and on Production Costs 15

Monetary Policy 20

The Flexibility of the Economy 22
VI THE ECONOMIC EFFECTS OF RECENT INCREASES IN ENERGY PRICES

Figures

1-1. Prices for Crude Oil and Natural Gas 2

1-2. Annual Change in Petroleum Consumption in Selected Regions, 2003 to 2005 3

2-1. Households’ Spending on Energy as a Percentage of Disposable Personal Income, 

1965 to the First Quarter of 2006 8

2-2. Households’ Real Spending on and the Relative Price of Motor Fuel and Fuel Oil, 

1970 to the First Quarter of 2006 8

2-3. Personal Saving Rate, 1965 to the First Quarter of 2006 9

2-4. Hourly Compensation, 1985 to the First Quarter of 2006 9

2-5. Measures of Capital Income, 1965 to the First Quarter of 2006 10

2-6. The U.S. Trade Balance and Petroleum Imports, 1965 to the 

First Quarter of 2006 11

3-1. Comparison of the Price of Crude Oil, Consumer Price Inflation, and 

GDP Growth, 1965 to the First Quarter of 2006 16

3-2. Consumer Confidence, 1965 to June 2006 17

3-3. Comparison of Energy Price Shocks 18

3-4. Business Fixed Investment, 1965 to the First Quarter of 2006 19

3-5. Real GDP of Foreign Economies, 1971 to the First Quarter of 2006 19

3-6. Real U.S. Exports, 1970 to the First Quarter of 2006 20

3-7. Energy Consumption and Gross Domestic Product 21

3-8. Single-Family Housing Starts, 1965 to the First Quarter of 2006 24
Summary

Contrary to general expectations, the large and 

persistent rise in energy prices that has occurred over the 

past two and a half years has not caused substantial problems for the overall U.S. economy. Although many 

households have had trouble adjusting to the higher 

prices, the effects on the nation’s gross domestic product 

(GDP), employment, and inflation have thus far been 

moderate. The reasons for that outcome include various 

interrelated factors—for example, the U.S. and many foreign economies were at robust points in the business cycle 

when energy prices began to rise, the Federal Reserve has 

built up a legacy of successful monetary policy, and the 

U.S. economy has changed over the past 25 years in ways 

that have increased its underlying flexibility and stability. 

Recent Developments in Energy Prices

Since late 2003, the price of crude oil has doubled, natural gas prices have temporarily hit new highs, and prices 

for coal and electricity have risen steadily. The most important of those increases, in terms of their effects, has 

been the rise in the price of crude oil. 

The consensus view as of July 2006 is that most of the increase in the price of oil will persist. That price may fall 

below its recent level of more than $70 a barrel, but because the increase stemmed largely from growth in the 

demand for oil rather than from a temporary reduction in 

the supply, market analysts do not expect the price of oil 

to be significantly lower, on average, over the next 10 

years. (In early 2004, by comparison, analysts expected 

the price of oil to be on the order of $30 a barrel for the 

following 10 years.)

The Economic Impact of Higher Prices

The recent increases in energy prices have dampened economic growth in the United States. The growth of real 

(inflation-adjusted) GDP was probably reduced by about 

a quarter of a percentage point in 2004 and by less than 

half a percentage point in 2005; so far this year, the reduction has been about a quarter of a percentage point. 

Therefore, GDP in 2006 is probably lower by about 

1 percent than it would have been if energy prices had 

not risen. 

In addition, the rise in energy prices added more than a 

percentage point to consumer price inflation in 2005, 

pushing it to 3 percent.1

 With energy prices excluded, 

however, consumer price inflation appears to have been 

only slightly higher than it would have been otherwise. If 

energy prices do not increase further and if monetary policy remains moderately restrictive, the rate of inflation is 

likely to fall back to about 2 percent a year by the end of 

2007. 

Households’ income and spending were both affected by 

the rise in energy prices. The growth of real hourly compensation slowed (the result of a slowdown in nominal 

wage growth combined with the increase in inflation). At 

the same time, the average household’s annual spending 

on energy goods and services rose by about $1,700 between 2003 and mid-2006, and their saving rate dropped 

sharply. The fall in the saving rate helped dampen the 

negative effects that higher prices would ordinarily have 

had on the economy in the short run. If households try to 

rebuild their savings, however, consumer spending may 

be diminished slightly over the next few years. 

Overall, corporations were less affected by the rise in energy prices than households were. The profits of nonenergy-producing firms grew less rapidly than they would 

have in the absence of the energy price hike, but corporate profits overall increased. Much of that rise reflected a 

continuation of previous trends, as companies continued 

1. In this paper, “consumer prices” refers to the personal consumption price index unless otherwise noted.
VIII THE ECONOMIC EFFECTS OF RECENT INCREASES IN ENERGY PRICES

to reduce debt-service costs and depreciation expenses 

grew slowly. In addition, of course, the profits of energyproducing companies increased sharply. Most energyusing industries were apparently able either to pass on the 

higher costs of energy to their customers or to compensate for those costs through slower growth in other production costs. Largely because the demand for goods and 

services remained strong, the level of businesses’ investment spending on structures and equipment, which began increasing in 2003, continued to be high in recent 

years despite rising energy prices. 

GDP is expected to largely rebound from its short-term 

losses, although the shift in energy prices is likely to keep 

the level of GDP over the next 10 years lower than it 

would have been otherwise. In addition, the U.S. standard of living will be depressed to a greater extent than 

will GDP. U.S. residents will have to exchange more of 

their production for a barrel of oil than would have been 

the case if energy prices had not risen, and that adverse 

change in the “terms of trade” will affect the standard of 

living in the United States for many years. 

Changes in the Economy’s Response 

Since the 1970s

The nation’s experience with oil price increases in the 

1970s led many people to believe that such increases 

would lead to sharp slowdowns in economic growth and 

persistently higher inflation. The absence of such severe 

effects in recent years has thus been surprising. 

Many of the problems associated with the oil price shocks 

of the 1970s, however, were unique to that period. The 

U.S. economy and some foreign economies were at weak 

points in the business cycle before the shocks hit, monetary policymakers had been unable to control inflation in 

the years before energy prices rose, and many aspects of 

the U.S. economy’s structure at that time made the economy less able to respond to price shocks than it is today. 
CHAPTER

1

Developments in Oil and

Natural Gas Markets Since 2003

Over the past two and a half years, the price of 

crude oil has doubled, and retail gasoline prices have risen 

by 87 percent. Relative to the general price level of the 

economy, the price of crude oil rose to its highest level 

since 1980, and the wellhead price of natural gas temporarily reached a new peak (see Figure 1-1). Although natural gas prices have since declined from that peak, they 

remain historically high, and analysts generally expect oil 

and natural gas prices to remain elevated. 

The underlying causes of those price increases have been 

strong demand combined with weak supply. A number of 

developments—such as the hurricanes of 2005 and reductions in output in Iraq and Nigeria—have interrupted 

the supply of crude oil and natural gas and the processing 

of energy products in recent years. But the primary force 

behind the steady rise in prices has been growth in the demand for energy. 

Increases in Demand

For crude oil, growth in demand around the world explains much of the price increase, whereas for natural gas, 

growth in demand in the United States has been the main 

factor. In 2004, oil consumption shot up in China and 

the United States and also grew in many other parts of 

the world (see Figure 1-2).1

 Members of the Organization of Petroleum Exporting Countries have apparently 

been limited in their ability to keep the supply of oil 

growing at the same pace as demand. Thus, the price 

rose, and a relatively large share of the growth in world oil 

supply had to come from other, high-cost regions. Although the growth of oil consumption stagnated or declined in 2005 in the United States, Europe, and the 

former Soviet Union, it continued to grow in Asia, the 

Middle East, and Latin America. 

The pressures on natural gas prices are more narrowly attributable to conditions in the United States. Although 

total annual consumption of natural gas has been relatively stable in recent years, new demand by electric utilities has introduced growing seasonal pressures on the supply of natural gas from U.S. production, imports, and 

underground inventories. Domestic production has been 

declining since 2003, despite record levels of exploration 

and development. Costly shipments from Canada and 

imports of liquefied natural gas have helped balance supply with demand but have put further upward pressure 

on prices. 

Restrictions on Supply

Growth in energy supplies has been disrupted by some 

specific events over the past two and a half years. Recently, production of crude oil has been hampered by 

civil unrest in Nigeria, foreign investors’ concerns about 

political developments in Russia, continuing attacks on 

oil fields and pipelines in Iraq, and hurricanes that struck 

the Gulf Coast of the United States. Those disruptions to 

supply reinforced the effects that growing demand had on 

prices. In addition, worries about the potential consequences of international objections to Iran’s nuclear program may have caused some oil businesses to stockpile 

part of their supply in recent months rather than sell it. 

In the next few years, new oil production is expected 

from the Caspian Sea region, West Africa, and perhaps 

Russia and the Middle East. But until those lower-cost 

supplies arrive, prices are likely to remain high, and a rel1. For an analysis of China’s role in the worldwide increase in 

demand for oil, see Congressional Budget Office, China’s Growing 

Demand for Oil and Its Impact on U.S. Petroleum Markets (April 

2006).
2 THE ECONOMIC EFFECTS OF RECENT INCREASES IN ENERGY PRICES

Figure 1-1.

Prices for Crude Oil and Natural Gas

(2000 dollars per million British thermal units)

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis; Department of Energy, Energy Information 

Administration; Department of Labor, Bureau of Labor Statistics; Wall Street Journal.

Notes: The price of crude oil is for West Texas intermediate. Before 1982, it refers to the posted price; after 1982, it refers to the spot price. 

The price of natural gas is the wellhead price, extended back to 1967 using the producer price index for natural gas. The series are 

converted to 2000 dollars using the gross domestic product chained price index.

The final values, for the second quarter of 2006, are estimated.

atively large amount of new demand will have to be met 

by higher-cost producers.

Refining of gasoline in the United States has been diminished by the 2005 hurricanes and by regulatory requirements for reformulated gasoline. Refineries that had accounted for 40 percent of the production of refined 

products in the United States were damaged or temporarily closed by the storms. Through the spring of 2006, 

three refineries—which together had accounted for 5 percent of the nation’s gasoline production capacity—were 

not yet fully operational. This year, further problems with 

gasoline production resulted from efforts to replace the 

MTBE in reformulated gasoline with ethanol. (MTBE is 

an additive that helps reduce some pollutants by increasing the oxygen content of fuels.) Refiners face claims in 

lawsuits that maintain that MTBE has contaminated 

groundwater. They have accelerated the replacement of 

MTBE with ethanol, but supplies have proved insufficient. The wholesale price of ethanol increased from 

$2.10 per gallon in January 2006 to about $3.60 per gallon in June, which has placed additional pressure on gasoline prices. New restrictions on the sulfur content of motor fuels have also added to refining costs.

For supplies of natural gas, the United States relies on domestic production to a greater extent than it does in the 

case of oil. Consequently, the large decline in natural gas 

production in the Gulf region as a result of the 2005 hurricanes had a significant effect on prices. Natural gas 

prices rose sharply—from $5.52 per 1,000 cubic feet 

(mcf) in early 2005 to a peak of $10.97 mcf in October 

2005—before falling back recently to $6.59 mcf. In June 

2006, natural gas production in the Gulf region was 

about 90 percent of the prehurricane level. 

1965 1975 1985 1995 2005

14

12

10

8

6

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0

Crude Oil, 1965 to the Second Quarter of 2006 

1965 1975 1985 1995 2005

14

12

10

8

6

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0

Natural Gas, 1967 to the Second Quarter of 2006 
CHAPTER ONE DEVELOPMENTS IN OIL AND NATURAL GAS MARKETS SINCE 2003 3

Figure 1-2.

Annual Change in Petroleum Consumption in Selected Regions, 2003 to 2005

(Millions of barrels per day)

Source: Congressional Budget Office based on data from the Department of Energy, Energy Information Administration, Monthly Energy 

Review (January 2006), Table 3.1b (for U.S. petroleum consumption), and International Energy Agency, Oil Market Report (January 17, 2006), p. 4 (for other countries’ petroleum consumption). 

a. Japan, Australia, and Asian countries other than China that are not members of the Organisation for Economic Co-operation and Development. 

b. In 2005, Europe’s change in consumption was near zero.

Unusually mild weather early in 2006 probably played a 

role in the recent easing of natural gas prices. Measured 

by heating degree-days (the temperature variation from 

65 degrees weighted by the population), the need for 

heating between January and March was 10 percent lower 

nationwide this year than it was in 2005 and 16 percent 

lower in the mid-Atlantic region, where gas is the dominant heating fuel.

Price Expectations for Oil

In part because the price increases for crude oil have been 

largely driven by demand, most oil market analysts believe prices will remain high for many years. In the past, 

when the price of oil rose because of an interruption in 

supply that was thought to be temporary, analysts expected the price to fall once supply bounced back. This 

time, however, the increase in demand appears to be long 

lasting, and many analysts believe that growing worldwide demand will continue to put upward pressure on oil 

prices for some time. Even among people who expect the 

price to decline from its recent level of more than $70 a 

barrel, few forecast that it will fall below $40 a barrel—

whereas $30 a barrel was considered the likely future 

price just two and a half years ago.

Before 2003, some major oil-rich nations (particularly 

Saudi Arabia) were producing significantly less than their 

capacity, and that spare capacity helped keep oil markets 

relatively calm. Today, however, worldwide production is 

close to its short-term limits. As a result, oil markets appear much more vulnerable than before to an interruption in supply or a rapid increase in demand. Even the 

threat of a reduction in supply of a few hundred thousand 

barrels per day causes sharp fluctuations in prices. 

United States China Other Asian

Countries

Middle East Europe Latin America Former

Soviet Union

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

2003 2004 2005

b

a

0

CHAPTER

2

The Economic Effects of Higher Oil and 

Natural Gas Prices

So far, the U.S. economy has adjusted relatively 

easily to the recent increases in energy prices. Those 

increases appear to have reduced the growth of real 

(inflation-adjusted) gross domestic product (GDP) by 

less than half a percentage point per year between 2004 

and 2006 and to have boosted inflation only temporarily. 

If energy prices remain near their current levels or rise 

further, GDP is likely to remain for an extended time below the level it would have attained if energy prices had 

not risen. Also, the standard of living of U.S. residents 

will be reduced to an even greater degree than will GDP. 

The Short-Term Impact of Price Rises 

During the 2004–2006 Period

Paying high prices for energy and using less of it affect 

both the production of and the demand for goods and 

services. The effects on demand, however, have by far the 

greater potential impact on GDP in the short run. Using 

less energy has only a small direct effect on production 

because, out of all the inputs to production (labor, structures and equipment, energy, and other raw materials), 

energy costs account for a relatively small share of output. 

The effects on demand—and the consequent indirect effects on production—could be much bigger because 

spending more on petroleum imports generally reduces 

spending on domestically produced goods and services.1

Despite those potentially large effects, demand for U.S.-

produced goods and services has held up well in recent 

years. The rise in energy prices slowed the growth of real 

household income significantly, and spending on petroleum imports and energy rose sharply. But the growth of 

consumer spending on nonenergy goods and services remained relatively high, largely because households’ saving 

rate declined. Overall corporate profits and businesses’ 

spending on investment also remained strong in spite of 

higher energy prices, while the profits of energy companies jumped significantly. 

Such short-term effects on supply or demand can be 

exacerbated or muted by government policies. Both 

microeconomic policies (primarily regulations, such as 

controls on energy prices) and macroeconomic policies 

(the conduct of monetary and fiscal policy) affect the way 

in which the economy responds to an increase in energy 

prices. As discussed in Chapter 3, differences in government policies are one reason that the energy price shocks 

of the 1970s took a much greater toll on the U.S. economy than the recent price rises have.

How Increases in Energy Prices Can Affect

Production and Demand

As noted in Chapter 1, the price of crude oil has doubled 

since the end of 2003. In that year, the total cost of oil 

was equal to about 2 percent of output (or GDP). Thus, 

the direct effect of a 10 percent loss in the supply of oil—

roughly associated with a 100 percent increase in price in 

the short run—would be a reduction in GDP of approximately 0.2 percent.2

 (With the recent price rise, the total 

cost of oil now accounts for about 31⁄2 percent of output, 

so a similar percentage increase in the price of oil today 

would have a larger direct effect.) 

The loss in output would be less if firms could use other 

sources of energy or otherwise find relatively low-cost 

ways to modify their production practices to conserve oil. 

However, some structures and equipment may be costeffective only in an environment of low energy prices and 

1. As used in this paper, “petroleum” refers to crude oil, natural gas 

liquids, and refined products such as gasoline and fuel oil.

2. See James D. Hamilton, “Oil and the Macroeconomy” (draft, 

Department of Economics, University of California, San Diego, 

August 24, 2005), available at http://dss.ucsd.edu/~jhamilto/

JDH_palgrave_oil.pdf.
6 THE ECONOMIC EFFECTS OF RECENT INCREASES IN ENERGY PRICES

become obsolete when energy prices rise. Retiring such 

equipment might result in a larger loss in output. Studies 

of that effect during the 1970s indicate that it was small, 

but a much greater reduction in energy availability could 

cause the effect of retiring obsolete equipment to be disproportionately larger.3

Compared with the direct effect on production, a doubling of crude oil prices would be likely to have a bigger 

impact on the demand for goods and services. That impact, in turn, would cause production to weaken. Both 

declines in demand and changes in the composition of 

demand would reduce production, which could slow the 

growth of GDP significantly. The impact on overall demand operates through three major channels:

B Higher prices for crude oil (and to a lesser extent for 

natural gas, of which the United States imports a 

smaller share) siphon off buying power from the 

United States as U.S. residents pay more for energy 

imports. The additional buying power overseas may 

not immediately translate into increased demand for 

U.S. exports, so one short-term effect of higher energy 

prices is a decline in demand for goods and services 

produced in the United States. That reduction in consumer demand tends to temporarily dampen investment and other spending as well, magnifying the 

negative effect on GDP growth. (Other spending falls 

because businesses that lose sales tend to slow their investment and employment, reducing household income and further lowering consumer spending.)

B A similar but smaller effect is the shift of income and 

wealth within the United States to energy producers 

and owners of energy assets. That shift can also temporarily reduce demand but to a smaller extent than 

does the channeling of spending overseas. 

B A large and sudden change in the price—or disruption 

in the supply—of an important consumer good can 

have a short-term impact on consumer spending by 

affecting consumer confidence. People may postpone 

some purchases that they can currently afford out of 

concern about how the disruption to the economy 

may affect their jobs or income in the future. 

In addition, increases in energy prices would induce 

changes in the composition of demand. Businesses and 

households would tend to purchase more items that 

helped them conserve energy (for example, demand for 

fuel-efficient vehicles would increase relative to demand 

for sport utility vehicles), and consumers would generally 

change the composition of their spending to increase the 

share of goods and services that were less energy intensive. 

Those shifts would cause some productive capacity to 

be idled even if the total amount of spending did not 

decline. 

Such effects reduce demand at the same time that the 

costs of production increase. In those circumstances, 

monetary policymakers potentially face a difficult decision. If they tighten policy by raising short-term interest 

rates to avoid an increase in inflation, they will exacerbate 

the drop in output and the rise in unemployment.

If they accommodate the temporarily higher inflation 

with easier monetary policy, output will not fall as much. 

But they risk inadvertently fostering a climate of inflationary expectations—that is, they risk creating the impression that inflation will remain high. Fortunately, the 

reaction of the core rate of inflation (which excludes 

prices for energy and food) to the recent increases in energy prices was not large enough to lead to the adoption 

of monetary policies that would have had major negative 

effects on the economy.

In addition to their impact on the overall economy, 

higher energy prices are likely to affect different households and firms differently. People with relatively high income and the few households that own significant 

amounts of stock in energy companies would probably 

maintain their spending more than other households 

would. Similarly, firms that produced energy or that were 

not energy intensive would be better able to maintain 

their employment and investment growth than would 

companies that were heavy users of energy.

Estimated Effects on GDP and Inflation Since 2003 

Although it is difficult to determine exactly how the 

economy would have fared if energy prices had not risen 

as much as they did, those price increases appear to have 

dampened the growth of GDP by roughly a quarter of a 

percentage point in 2004, less than half of a percentage 

point in 2005, and about a quarter of a percentage point 

so far this year. Thus, the level of GDP in 2006 is about 

1 percent lower than it would have been otherwise. 

3. Charles R. Hulten, James Robertson, and Frank Wykoff, “Energy 

Obsolescence and the Productivity Slowdown,” in Dale W. Jorgenson and Ralph Landau, eds., Technology and Capital Formation

(Cambridge, Mass.: MIT Press, 1989).
CHAPTER TWO THE ECONOMIC EFFECTS OF HIGHER OIL AND NATURAL GAS PRICES 7

So far, the recent increases in energy prices had their peak 

effect on consumer price inflation in 2005. The higher 

prices that consumers faced for energy not only added 

about a percentage point to the inflation rate that year 

but also affected nonenergy consumer prices. The extent 

of that effect is uncertain, but nonenergy prices appear to 

have grown by about half a percentage point more than 

they would have if energy prices had not risen. 

The small change in core inflation thus far implies that if 

energy prices remained fairly steady from now through 

the end of 2007, overall inflation would fall back from its 

current rate of about 31⁄2 percent to about 2 percent next 

year. That is, the increase in energy prices would not 

cause inflation to be persistently higher.

Those estimates are based on a macroeconomic model by 

Global Insight, an economic analysis and forecasting 

firm. The Congressional Budget Office (CBO) used the 

model to simulate what would have happened to the 

economy if energy prices during the 2004–2006 period 

had grown by about 2 percent per year (the average 

growth of the GDP price index in the years before the energy price increase) and then compared that simulation 

with actual outcomes. The simulation assumed that monetary policy would react to changes in inflation and employment.4

The structure of the Global Insight model partially captures the major short-term effects of higher energy prices: 

the reduction in nonenergy consumption and investment, the impact of that reduction on employment and 

personal income, and the likely consequences for financial markets. Thus, the model provides estimates of what 

would have happened if energy prices had not risen. The 

model may not reflect all of the effects adequately, however. It is not designed specifically to simulate the response to changes in energy prices; rather, it embodies 

households’ and firms’ average responses to a variety of 

economic shocks that have occurred in the past. Also, the 

U.S. economy has changed in many structural ways over 

the years, and the model’s equations may not capture the 

effects of those changes adequately. In spite of those 

shortcomings, the Global Insight model probably yields 

reasonable rough estimates of how the economy would 

have performed in the absence of the price increases. 

Econometric modeling work at the Federal Reserve using 

a variety of models has yielded some similar estimates of 

the effect of the energy price increases on GDP growth.5

Effects on Households

The rise in energy prices has affected households’ income, 

spending, and saving rates. Real household income has 

grown less rapidly in the past few years than it would 

have if energy prices had not risen substantially. That 

slower growth reflects the direct effect of higher energy 

prices on consumer price inflation as well as a slowdown 

in the growth of the economy overall. Consumer price inflation increased as the growth of hourly compensation 

(wages and employer-provided benefits, such as health insurance) slowed. Consequently, the real growth of compensation fell as energy prices rose. 

Households are spending much more on energy goods 

and services today than they were in 2003. Such spending 

totaled about $580 billion per year in the second quarter 

of 2006, up from about $380 billion per year at the end 

of 2003. That $200 billion difference implies that annual 

energy spending per household rose by an average of 

about $1,700 over that period. The increase in the price 

of energy relative to the prices of other goods and services 

also caused a rapid rise in the ratio of energy spending to 

disposable income (see Figure 2-1), even though nominal 

disposable income per household was about $9,000 

greater in mid-2006 than it was in 2003. 

So far, higher prices have had little effect on the amount 

of motor fuel and fuel oil used per household (see 

Figure 2-2). If prices remain elevated, however, households are likely to try to reduce their energy consumption 

in the future. 

Increases in energy prices can have offsetting effects on 

the amount of money that households save. On the one 

hand, the overall personal saving rate tends to decline 

when the price of energy rises rapidly (although the response differs among individual households). On the 4. The simulation used a version of the Taylor rule, described 

in John B. Taylor, “Discretion Versus Policy Rules in Practice,” Carnegie-Rochester Conference Series on Public Policy, 

vol. 39 (December 1993), pp. 195–214, available at

www.sciencedirect.com.

5. See Donald L. Kohn, “Economic Outlook” (remarks at the Bankers and Business Leaders Luncheon, Federal Reserve Bank of Kansas City, April 13, 2006).
8 THE ECONOMIC EFFECTS OF RECENT INCREASES IN ENERGY PRICES

Figure 2-1.

Households’ Spending on Energy as a 

Percentage of Disposable Personal 

Income, 1965 to the First Quarter of 

2006

(Percent)

Sources: Congressional Budget Office; Department of Commerce, 

Bureau of Economic Analysis. 

other hand, the effect of the price increases on people’s 

expectations about the future may initially encourage 

households to try to save more. Relatively wealthy or 

high-income households can maintain their spending on 

nonenergy goods and services while also spending more 

on energy, thus lowering their saving rate. Lower-income 

households, by contrast, generally have to curtail other 

spending to maintain their energy consumption. Some 

lower-income households may also be able to reduce their 

saving or increase their debt to pay for some of the increase in their energy costs, but others have limited access 

to credit and have to cut nonenergy spending. Changes in 

consumer confidence can also affect decisions about 

spending as people postpone large purchases—of vehicles 

or appliances, for example—until they are more sure 

about how higher energy prices will affect their jobs and 

income in the future. Deferring such purchases tends to 

increase the saving rate in the short run.

The extent to which individuals have drawn down their 

savings or increased their debt to finance greater energy 

spending is difficult to estimate accurately. But preliminary data show that the personal saving rate fell unusually 

quickly between late 2003 and mid-2006—by about 3 

percentage points (see Figure 2-3). Much of that drop 

probably stems from the rapid increase in housing-related 

wealth during the period. If households spent some of 

that increase in wealth—perhaps after refinancing their 

mortgages—they could consume more relative to their 

income, lowering their saving rate. The rising cost of energy appears to have encouraged households to lower 

their saving rate in order to maintain their spending. 

Households’ ability and willingness to reduce their saving 

blunted the adverse impact that higher energy prices 

Figure 2-2.

Households’ Real Spending on and the 

Relative Price of Motor Fuel and Fuel 

Oil, 1970 to the First Quarter of 2006

(Chained 2000 dollars) (Ratio)

Sources: Congressional Budget Office; Department of Commerce, 

Bureau of Economic Analysis and Bureau of the Census. 

Note: Data were smoothed using a four-quarter moving average. 

The number of households was adjusted to remove discontinuities in the data series in January 1982 and January 2002. 

a. The relative price is the ratio of the chained price index for consumer nondurable energy goods to the gross domestic product 

chained price index.

1965 1975 1985 1995 2005

9

8

7

6

5

4

0

1970 1975 1980 1985 1990 1995 2000 2005

2,250

2,150

2,050

1,950

1,850

1,750

1,650

0

1.8

1.6

1.4

1.2

1.0

0.8

0

Real Spending 

per Household 

(Left scale)

Relative Pricea

(Right scale)
CHAPTER TWO THE ECONOMIC EFFECTS OF HIGHER OIL AND NATURAL GAS PRICES 9

Figure 2-3.

Personal Saving Rate, 1965 to the First 

Quarter of 2006

(Percent)

Sources: Congressional Budget Office; Department of Commerce, 

Bureau of Economic Analysis.

would ordinarily have had on demand, because otherwise 

consumers would have had to cut back on nonenergy 

spending. The growth of nonenergy consumption does 

not appear to have been significantly depressed so far, although the effect of higher energy prices may slow the 

growth of such spending in the future if households try to 

rebuild their savings.

The rise in energy prices also dampened increases in 

households’ inflation-adjusted income. The growth of 

one measure of real compensation per hour—the employment cost index divided by the personal consumption price index—slowed from 2 percent at the end of 

2003 to about zero by early 2006 (see Figure 2-4). CBO’s 

model simulation indicates that real wages would have 

grown about half a percentage point faster in 2004 and 

about three-quarters of a percentage point faster in 2005 

if energy prices had not risen. The growth of employment 

would also have been slightly faster.

Effects on Firms 

Overall, the income and spending of the corporate sector 

appear to have been little affected by the rise in energy 

prices. Corporate profits fared better than household income over the past two and a half years, but much of the 

increase in profits was unrelated to the change in energy 

prices. Corporate profitability in general grew rapidly, 

and energy producers in particular recorded large gains in 

profits. Preliminary data indicate that corporations’ total 

economic profits rose to a 40-year high in early 2006 relative to GDP (see Figure 2-5). That increase partly reflected a continuation of trends that predated the rise in 

energy prices. Firms continued to restructure debt to take 

advantage of low long-term interest rates, and depreciation charges against profits grew slowly in response to low 

investment rates from mid-2000 to early 2003. Adding 

those costs to profits provides a rough measure of the 

gross income that companies earned as a return on capital. That measure shows much less increase over the past 

few years than do profits alone. CBO’s model simulation 

suggests that corporate profits would have been slightly 

higher if energy prices had not risen. 

Figure 2-4.

Hourly Compensation, 1985 to the 

First Quarter of 2006

(Percentage change from previous year)

Sources: Congressional Budget Office; Department of Labor, Bureau 

of Labor Statistics; Department of Commerce, Bureau of 

Economic Analysis.

a. The employment cost index for private-sector employees 

divided by the chained price index for personal consumption 

expenditures.

1965 1975 1985 1995 2005

15

10

5

0

-5

1985 1990 1995 2000 2005

6

5

4

3

2

1

0

-1

Real

Compensation

per Houra

Nominal

Compensation

per Hour
10 THE ECONOMIC EFFECTS OF RECENT INCREASES IN ENERGY PRICES

Figure 2-5.

Measures of Capital Income, 

1965 to the First Quarter of 2006

(Percentage of gross domestic product)

Sources: Congressional Budget Office; Department of Commerce, 

Bureau of Economic Analysis.

Note: Economic profits are corporate profits adjusted to remove 

distortions in depreciation allowances caused by tax rules 

and to exclude the effects of inflation on the value of 

inventories.

Nevertheless, energy-producing firms account for a significant part of the recent growth in profits. According to 

Standard & Poor’s data for publicly traded firms, the 

profits of oil and natural gas companies rose from 

$97 billion in 2003 to $219 billion in 2005.

It appears that energy-using firms have generally been 

able to maintain profit growth by passing a large share of 

the higher energy costs on to their customers and by 

keeping labor costs from rising with inflation. (As noted 

above, the growth of real labor compensation per hour 

has fallen during the past two and a half years.)

Because higher energy prices slowed the growth of demand only slightly and did not have a large negative effect on profits, corporations maintained the pace of their 

investment spending. The growth of firms’ spending on 

structures and equipment, which had started a strong recovery in 2003, was not adversely affected. In fact, higher 

energy prices stimulated investment in energy exploration 

and in oil and gas wells. Overall, real business fixed investment grew by about 9 percent in both 2004 and 2005 

and appears likely to rise even faster this year.

Effects on the Trade Deficit and Interest Rates 

The jump in the price of petroleum imports has caused 

the U.S. trade deficit to widen. But the additional savings 

accumulated by petroleum-exporting countries may have 

kept long-term interest rates in the United States somewhat lower than they would have been otherwise. 

Higher energy prices have had a number of effects on the 

trade deficit. In nominal terms, U.S. spending on imported petroleum rose from $133 billion at the end 

of 2003 to more than $300 billion by the middle of 

2006—or from 1.2 percent of GDP to 2.3 percent (see 

Figure 2-6). That rise has contributed to the growth of 

the U.S. trade deficit over the past two and a half years. 

Other changes, however—such as an increase in the 

growth of U.S. exports to oil-exporting countries and a 

slight reduction in U.S. residents’ ability to purchase 

nonoil imports—have partly offset the effect of petroleum imports on the trade deficit. Recently, the growth in 

the amount of petroleum imported relative to the size of 

the economy (real GDP) has slowed. 

Because of an increase in total saving worldwide, the rise 

in energy prices may have slightly reduced long-term 

interest rates in the United States relative to what they 

would have been. Saving in petroleum-producing countries went up more than saving in petroleum-importing 

countries fell, so additional worldwide saving was available for investment. Even if those additional funds were 

not directly invested in dollar-denominated assets, they 

would keep U.S. interest rates lower than would otherwise be the case, because a decline in interest rates for 

other currencies would tend to encourage third parties to 

invest in dollar-denominated assets in the United States. 

The Impact of the Recent Energy Price 

Increases over the Next Ten Years

The recent shift to higher energy prices is likely to reduce 

the level of real GDP over the next decade but is unlikely 

to have a persistent effect on inflation. In addition, if the 

price rises prove permanent, the level of the standard of 

living in the United States will be reduced by more than 

the level of GDP.

1965 1975 1985 1995 2005

25

20

15

10

0

Corporations’ 

Economic

Profits 

Corporations’ Economic 

Profits, Interest Payments, 

and Depreciation 
CHAPTER TWO THE ECONOMIC EFFECTS OF HIGHER OIL AND NATURAL GAS PRICES 11

Figure 2-6.

The U.S. Trade Balance and 

Petroleum Imports, 1965 to the 

First Quarter of 2006

(Percentage of gross domestic product)

Sources: Congressional Budget Office; Department of Commerce, 

Bureau of Economic Analysis.

As noted earlier, an increase in energy prices in the short 

run has much greater potential to alter GDP through its 

effects on demand than through its direct effects on production. Over the longer term, however, the effects on 

production may be more important. After a few years, 

households and firms will adjust to the change in relative 

prices, and total demand for goods and services will tend 

to return to a level that will keep resources in the economy fully employed. Therefore, any longer-term effects 

on GDP will stem from the impact on productive capacity—that is, the levels of productivity, the capital stock, 

and the labor force. 

Past Evidence of Effects on Productivity

The level of productivity of capital and labor is likely to 

be lower over the next 10 years because of the recent rise 

in energy prices, even though the evidence indicates that 

higher energy prices do not permanently reduce the 

growth of productivity. The lower level stems from a temporary slowing in the growth of productivity that will not 

be made up in subsequent years if energy prices remain 

high.

To estimate the effects of higher energy prices on the 

long-term growth of the productivity of capital and labor, 

economists have analyzed the impact of the energy price 

increases of the 1970s. Some analysts have blamed a rise 

in oil prices for a slowdown in productivity that began in 

the early 1970s, largely because that price rise roughly coincided with the beginning of a period of subpar growth 

in total factor productivity.6 After growing at an average 

annual rate of 2.1 percent from 1950 to 1973, total factor 

productivity increased by just 0.8 percent a year, on average, between 1973 and 1994.

In principle, higher prices for imported oil will reduce the 

growth of productivity for some time. Businesses will reallocate resources in response to the higher prices, diverting some resources from their best possible use under the 

old set of prices and redirecting them to their best possible use under the new set of prices. Essentially, firms 

will substitute away from oil; they will also divert resources away from other uses in order to pay for the 

more-expensive oil that they do use. Some output will inevitably be lost as resources are diverted from other uses. 

That process will harm productivity growth while the adjustment is going on, but the growth of productivity 

should not be affected once all of the adjustments are 

complete.

In practice, however, higher energy costs do not appear to 

explain any permanent reduction in the growth of productivity. Energy was too small a share of the economy in 

the early 1970s to account for more than a small part of 

the productivity slowdown that began in 1973. As noted 

earlier, the direct impact on production in the short run 

of a decline in the use of oil is measured by oil’s share 

of total GDP. Given that oil costs accounted for roughly 

2 percent of total output in 1973, a 10 percent reduction 

in the use of oil would produce a one-time reduction in 

output of no more than 0.2 percent.7

Some analysts have reasoned that the energy cost increases of the 1970s had a disproportionate impact on the 

1965 1975 1985 1995 2005

4

2

0

-2

-4

-6

-8

U.S. Trade 

 Balance

U.S. Petroleum Imports

6. Total factor productivity is average real GDP per unit of combined labor and capital services. The growth of total factor productivity is defined as the growth of real GDP that is not 

explained by the growth of labor and capital.

7. See Hamilton, “Oil and the Macroeconomy.”
12 THE ECONOMIC EFFECTS OF RECENT INCREASES IN ENERGY PRICES

economy because they affected investment or innovation 

by enough to permanently reduce the growth of productivity. One prominent explanation is centered on the idea 

that the increase in energy costs rendered part of the capital stock obsolete.8

 In that view, productivity growth 

slowed because some energy-intensive capital was taken 

out of service, thus reducing output, but the decline in 

capital services went unmeasured in economic statistics. 

That capital-obsolescence view was partly undermined by 

a more recent study, which concluded that the relative 

price of used equipment on the secondary market was 

largely unaffected by the increase in oil prices.9 If that increase had caused some capital goods to become obsolete, 

the price of used energy-intensive equipment would most 

likely have fallen. However, it is possible that the study 

did not capture some of the short-term effects or the effects on some types of structures and equipment, since 

there is no secondary market for major parts of the capital 

stock, such as furnaces for steel plants, chemical factories, 

and the like. 

Evidence about the role of energy costs in the productivity slowdown that began in the mid-1970s is still inconclusive. Some empirical studies that analyze productivity 

growth using industry data indicate that the slowdown 

from 1973 to 1994 was concentrated in energy-intensive 

sectors of the economy;10 other studies find no such 

effect.11

Researchers have proposed several other explanations for 

the slowdown in productivity. Those explanations include a decline in spending for research and development, an increase in environmental or worker-safety regulations, a misallocation of resources arising from high 

tax rates or high inflation, a general lessening of competitive pressure on businesses, or a shift in the structure of 

the economy away from manufacturing and toward service industries. However, those explanations still cannot 

account for the sharp drop in productivity growth that 

began in the mid-1970s.

Although the recent increase in energy prices is unlikely 

to reduce the growth of productivity permanently, that 

growth will probably be lower for a few years because of 

the need to reallocate resources. The temporary losses in 

productivity will not be made up in subsequent years, so 

the level of productivity in the long run is likely to be 

lower than it would have been without the energy price 

increase.

Effects on the Capital Stock and the Labor Force

The levels of both the labor force and the capital stock 

(structures and equipment) 10 years from now will probably also be slightly lower than they would have been if 

energy prices had not risen. Individuals’ decisions to work 

(particularly in the case of second wage earners in households and people on the verge of retirement) are affected 

by the level of real compensation. If energy costs remain 

high, the prices of consumer goods and services, which 

include imports, will be higher relative to the prices of the 

goods and services that U.S. workers produce. Since employees’ compensation tends to grow in line with their 

contribution to the value of the goods they are producing, a relative increase in consumer prices will tend to reduce the level of real compensation. Such a reduction will 

most likely dissuade some people from working, and the 

overall labor force in the United States will be slightly 

smaller. 

The capital stock will tend to be smaller as well, although 

the extent of the reduction is difficult to estimate. As 

mentioned above, some equipment will be retired early 

because of obsolescence, temporarily reducing the size of 

the capital stock. Once firms adjust to the new level of 

energy prices, however, the growth rate of the capital 

stock will probably return to its previous trend. The reduction in productive capacity during the transition period will not necessarily be made up, so the level of the 

capital stock may be permanently lower than it would 

have been if energy prices had not increased.

Effects on Inflation 

A higher price for oil will raise the level of prices and 

temporarily speed up the growth of price inflation, but it 

is unlikely to permanently increase that rate of growth. 

Ultimately, the inflation rate depends on the Federal Re8. Martin Baily, “Productivity and the Services of Labor and Capital,” Brookings Papers on Economic Activity, no. 1 (1981), pp. 1–50.

9. Hulten, Robertson, and Wykoff, “Energy Obsolescence and the 

Productivity Slowdown.” 

10. Dale W. Jorgenson, “Productivity and Postwar U.S. Economic 

Growth,” Journal of Economic Perspectives, vol. 2, no. 4 (Fall 

1988), pp. 23–41; and William Nordhaus, Retrospective on the 

1970s Productivity Slowdown, Working Paper No. 10950 (Cambridge, Mass.: National Bureau of Economic Research, December 

2004), available at www.nber.org/papers/W10950.

11. Douglas R. Bohi, “On the Macroeconomic Effects of Energy Price 

Shocks,” Resources and Energy, vol. 13, no. 2 (1991), pp. 145–162, 

available at http://econpapers.repec.org/article/eeereseng/.
CHAPTER TWO THE ECONOMIC EFFECTS OF HIGHER OIL AND NATURAL GAS PRICES 13

serve, whose policies could neutralize the effects of higher 

energy prices on the overall price level, could accommodate their effects, or could exacerbate them, leading to 

persistent inflation.

Effects on the Standard of Living

Because the United States imports a substantial part of 

the energy it needs, energy price increases have a larger 

negative effect on the standard of living of U.S. residents 

than on the level of real GDP per capita. If all of the petroleum used in the United States were produced domestically, higher oil prices would not lower the overall U.S. 

standard of living in the long run by any more than they 

would lower GDP. But since the United States imports 

petroleum and since U.S. residents have to trade more of 

their production for a barrel of oil than they did before 

the price increased, the standard of living is lower. (The 

effect on living standards is greater than the effect on 

GDP because the way GDP is measured does not take 

into account how much more of their production U.S. 

residents have to trade for imports.) 

Estimating the magnitude of the reduction in living standards is problematic because it depends on how easily 

households and businesses can decrease their use of oil 

products—that is, on the extent to which efforts to conserve energy reduce consumers’ standard of living and increase companies’ costs of production. New technologies 

or methods of energy use may make those adjustments 

less costly in the future than they appear to be today.

CHAPTER

3

Why Have the Negative Effects of Recent Energy Price 

Increases Been Smaller Than Those in the 1970s?

In the past, large increases in oil prices coincided with 

major macroeconomic problems: recessions and higher 

inflation. For example, the jump in oil prices that began 

in late 1973 occurred at the same time as an increase in 

core consumer price inflation and just before the 1973–

1975 recession (see Figure 3-1). Likewise, the oil price increases of the 1979–1980 period coincided with higher 

inflation and the 1980 recession. The price hikes of 1990 

and 1999 also appear to have been related to recessions 

and increases (albeit short-lived) in inflation. Given that 

record, why has the economic impact this time, as described in Chapter 2, been relatively mild? 

Accounting for differences between the effects of energy 

price increases in the 1970s and over the past few years is 

complicated by the variety of possible explanations, many 

of which are interrelated. Separating the explanations 

into three levels helps clarify the differences between the 

time periods. The first level focuses primarily on the immediate cyclical effects of higher energy prices on the demand for U.S.-produced goods and services, as evidenced 

by consumers’ spending and businesses’ investment. That 

level of explanation highlights the reasons that households were able and willing to draw down their savings 

during the recent oil price hike, why firms continued to 

invest, and why U.S. exports remained strong. 

The second level of explanation focuses on the role of 

monetary policy and inflation before and during the increases in energy prices. In the years prior to both of the 

oil price shocks of the 1970s, monetary policy had not 

been able to keep inflation under control, and firms and 

households had come to expect persistently high inflation. When the shocks occurred, that environment of 

high inflationary expectations caused monetary policymakers to tighten policy much more than has been 

needed during the past few years. That level of explanation rests on the effects of monetary policy on spending 

by households and firms and on companies’ pricing behavior. In so doing, it provides a complementary view of 

how increases in energy prices affected demand. 

The third level examines underlying, or structural, differences between the economy in the 1970s and today, 

which appear to have made oil price hikes generally less 

pernicious and the task of monetary policymakers less 

onerous. Some aspects of that level of explanation are 

more speculative than the first two levels because they 

rely on indirect evidence of the economy’s “flexibility,” or 

ability to adjust quickly to changes in the relative availability and prices of goods and services. If prices can adjust rapidly to reflect relative scarcities, then, in principle, 

scarce items will be put to their most valued uses, and the 

negative effect on output will be limited. In that case, a 

price shock does not pose as difficult a policy decision for 

the Federal Reserve as it would if price setting were more 

rigid and output losses were greater. 

Immediate Effects on Demand and on 

Production Costs

Three major categories of overall demand—consumer 

spending, business investment, and exports—remained 

strong during the recent rise in energy prices, whereas 

they faltered in the early phases of the 1970s shocks. 

However, the direct effect of higher energy prices on production did not have a large impact in either period. 

Consumer Spending

The persistence of strong consumer spending on nonenergy goods and services in the face of higher energy costs 

since 2004 is a dramatic departure from the situation 

three decades ago. A measure of consumer confidence, 

which can be used as an indicator of both current income 

and households’ expectations for the near future, has been 
16 THE ECONOMIC EFFECTS OF RECENT INCREASES IN ENERGY PRICES

Figure 3-1.

Comparison of the Price of Crude Oil, Consumer Price Inflation, and 

GDP Growth, 1965 to the First Quarter of 2006

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis; Department of Labor, Bureau of Labor Statistics; Wall Street Journal.

Notes: The price of crude oil is for West Texas intermediate. Before 1982, it refers to the posted price; after 1982, it refers to the spot price. 

The series is converted to 2000 dollars using the GDP chained price index.

The CPI-U is the consumer price index for all urban consumers; the core CPI-U excludes food and energy prices. Data for the CPI-U 

were smoothed using a four-quarter moving average.

1965 1975 1985 1995 2005

10

8

6

4

2

0

-2

-4

Percentage Change from Previous Year 

 Core 

CPI-U

1965 1975 1985 1995 2005

80

60

40

20

0

2000 Dollars per Barrel 

1965 1975 1985 1995 2005

14

12

10

8

6

4

2

0

Percentage Change from Previous Year 

Total CPI-U 

Price of Crude Oil Consumer Prices 

Gross Domestic Product 
CHAPTER THREE WHY HAVE THE NEGATIVE EFFECTS OF RECENT ENERGY PRICE INCREASES BEEN SMALLER THAN THOSE IN THE 1970S? 17

Figure 3-2.

Consumer Confidence, 1965 to 

June 2006

(Index, first quarter of 1966 = 100) 

Sources: Congressional Budget Office; University of Michigan.

Notes: The measure of consumer confidence shown here is the University of Michigan’s Index of Consumer Sentiment. 

Data were smoothed using a three-month moving average.

much stronger recently than it was during the oil price 

increases of the 1970s (see Figure 3-2). That attitude has 

apparently encouraged people to continue to spend even 

as the growth of income has slowed. Differences between 

consumers’ recent behavior and their behavior in the 

1970s can also be seen in the personal saving rate (shown 

in Figure 2-3 on page 9). 

Consumer confidence and spending in recent years were 

probably supported by increases in housing wealth as well 

as by various economic developments over the past quarter century—such as the record of successful inflation 

management by the Federal Reserve and changes in the 

economy that may have reduced the adverse impacts of 

price shocks. (Those developments are discussed in more 

detail later in this chapter.) In the 1970s, households 

lacked confidence in the stability of the economy or the 

ability of monetary authorities to control inflation. In recent years, households have been less concerned about 

their jobs and future income and more willing and able—

helped in part by increases in housing wealth—to borrow 

to maintain their spending. 

Some analysts have argued that consumers cut back more 

sharply in the 1970s because energy prices rose more rapidly then. However, it is difficult to attribute the variation 

in consumers’ response to that difference. Gasoline prices 

rose less sharply this time in the first year of the price increases, but they grew at about the same or a greater rate 

over two and a half years than they did in the 1970s. 

Moreover, the speed with which gasoline prices rose during the second year of the recent increases was as high as 

in any previous episode. In addition, natural gas prices for 

consumers grew more during the recent episode than 

they did earlier (see Figure 3-3). Differences in the speed 

of various energy price increases do not appear to be large 

enough to explain the differences in the response of

consumers.

Business Investment

Companies’ level of investment in structures, equipment, 

and software varies widely over the business cycle—to a 

much greater degree than consumer or government 

spending does. In addition, business fixed investment 

tends to create its own cycle through the interaction of 

short-term effects. An increase in demand for goods and 

services creates a need for businesses to build up their 

capital stocks, which in turn produces more employment 

and more demand for goods and services, and thus a demand for even more capital stocks. That view of investment behavior does not explain all of the variations in 

investment over history (a number of other factors can 

affect investment spending). But elements of that pattern 

are present in the business cycles of the post-World 

War II era. 

The energy price shocks of the 1970s occurred when 

business investment was already weakening. In 2003, by 

contrast, business investment was just beginning an upturn. Business fixed investment had been hitting new 

highs as a share of potential gross domestic product in the 

years before the earlier energy price shocks, but it was 

extraordinarily low before the most recent increase (see 

Figure 3-4). Models of investment behavior indicate that 

in the late 1970s, the capital stock was large relative to 

firms’ desired levels of capital (that is, the levels they felt 

would be appropriate given demand and employment 

growth). In 2003, however, the capital stock was below 

the levels that firms considered optimal to meet the 

1965 1975 1985 1995 2005

120

100

80

60

0
18 THE ECONOMIC EFFECTS OF RECENT INCREASES IN ENERGY PRICES

Figure 3-3.

Comparison of Energy Price Shocks

(Index, base period = 100)

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis; Department of Energy, Energy Information 

Administration; Department of Labor, Bureau of Labor Statistics; Wall Street Journal.

Notes: The base periods are the third quarter of 1973 for the 1973-1974 price shock, the first quarter of 1979 for the 1979-1980 price shock, 

and the fourth quarter of 2003 for the 2004-2005 price shock. 

The price of crude oil is for West Texas intermediate. Before 1982, it refers to the posted price; after 1982, it refers to the spot price. 

The wellhead price of natural gas was extended back to 1970 using the producer price index for natural gas. 

CPI-U = consumer price index for all urban consumers.

Values for the second quarter of 2006 were estimated.

-3

Years

-2

 Years

-1

 Year

Base

Period

+1

 Year

+2

Years

+3

Years

0

50

100

150

200

250

300

2004-2005

1979-1980

1973-1974

Price of Crude Oil

-3

Years

-2

 Years

-1

 Year

Base

Period

+1

 Year

+2

Years

+3

Years

0

50

100

150

200

250

2004-2005

1979-1980

1973-1974

Wellhead Price of Natural Gas

-3

Years

-2

 Years

-1

 Year

Base

Period

+1

 Year

+2

Years

+3

Years

0

60

80

100

120

140

160

180

CPI-U for Motor Fuel

2004-2005

1979-1980

1973-1974

-3

Years

-2

 Years

-1

 Year

Base

Period

+1

 Year

+2

Years

+3

Years

0

70

80

90

100

110

120

130

140

150

CPI-U for Natural Gas Piped to Residences

1979-

1980

2004-2005

1973-1974
CHAPTER THREE WHY HAVE THE NEGATIVE EFFECTS OF RECENT ENERGY PRICE INCREASES BEEN SMALLER THAN THOSE IN THE 1970S? 19

Figure 3-4.

Business Fixed Investment, 1965 to the 

First Quarter of 2006

(Percentage of potential gross domestic product) 

Sources: Congressional Budget Office; Department of Commerce, 

Bureau of Economic Analysis.

Note: Potential GDP is the level of gross domestic product that 

corresponds to a high level of resource (labor and capital) 

use.

demand for goods and services at that time.1 Thus, the 

demand for capital was able to partially offset the negative impact of higher energy prices in recent years, 

whereas it tended to worsen the response to the 1979–

1980 price hike and had a mildly negative effect during 

the 1973–1974 price increase.

Exports

In recent years, higher energy prices have also had less impact than they did earlier on other countries’ economic 

growth, the amount of U.S. exports, and the prices of 

U.S. imports. As a result, demand from abroad has provided more support lately for U.S. growth with low 

inflation. 

The growth of both foreign GDP and U.S. exports has 

been much stronger in the past two years than it was during the 1970s energy price shocks. Economic growth in 

the rest of the world slowed markedly in 1974 and 1980 

after oil prices rose (see Figure 3-5). As a result, real U.S. 

exports of goods weakened—particularly in the 1973–

1974 price shock—dampening economic growth in the 

United States (see Figure 3-6). Foreign GDP growth 

slowed in 2005 as well, but the effect was much smaller 

than that of 1974 and somewhat smaller than that of 

1980. 

The prices of goods imported into the United States (excluding petroleum and computers) also behaved very differently in recent years than during the 1970s. Import 

prices rose by 22 percent in 1973 and 13 percent in 1979 

but by an average of just 3 percent in 2004 and 2005. 

Whereas in the 1970s the U.S. economy was operating in 

an environment of high worldwide inflation, in recent 

years the international environment has been one of nearzero average inflation for tradable goods other than oil. 

Figure 3-5.

Real GDP of Foreign Economies, 1971 

to the First Quarter of 2006

(Percentage change from previous year)

Source: Congressional Budget Office. 

Note: This figure shows the growth of real gross domestic product 

for 16 major U.S. trading partners, weighted by those countries’ shares of total exports from the United States.

1. For a discussion of an investment model, see Mark Lasky, A PuttyClay Model of Business Fixed Investment, CBO Technical Paper 

2003-09 (September 2003), available at www.cbo.gov/ftpdocs/

45xx/doc4573/2003-9.pdf.

1965 1975 1985 1995 2005

14

13

12

11

10

9

0

1970 1975 1980 1985 1990 1995 2000 2005

10

8

6

4

2

0
20 THE ECONOMIC EFFECTS OF RECENT INCREASES IN ENERGY PRICES

Figure 3-6.

Real U.S. Exports, 1970 to the First 

Quarter of 2006

(Billions of chained 2000 dollars, log scale)

Sources: Congressional Budget Office; Department of Commerce, 

Bureau of Economic Analysis.

Assessing the reasons for those differences in the economic performance of the United States’ trading partners 

is beyond the scope of this analysis, but some of the reasons may be similar to those for the United States. First, 

at the outset of the most recent energy price increase, the 

economies that purchase U.S. goods were in a cyclical upswing (reflected by the fact that the price increase was 

driven more by the growth of demand than by restrictions on supply). Second, monetary policy has generally 

been managed better in developed countries worldwide. 

And third, there appears to have been a general evolution 

toward more market-oriented economies.2

Costs of Production

One commonly cited explanation for the smaller economic effects this time is that production is less dependent on energy now than it was in the 1970s. Proponents 

of that view argue that producers can adapt to higher energy prices more easily today since the economy is less energy intensive, both because the share of GDP accounted 

for by services (such as medical care) has increased and 

because the economy uses energy more efficiently. 

That factor does not appear to be particularly important, 

however. The energy intensity of the U.S. economy—

measured as British thermal units (Btus) of energy used 

per unit of constant-dollar GDP—has indeed declined 

(see Figure 3-7). But in nominal terms, the share of petroleum use in the economy was not significantly different in 2003 than it was in 1973, and it is the nominal 

share of energy use that determines the direct effect on 

production of having to use less energy, not the ratio of 

Btus to real GDP. The latter measure does not capture the 

higher cost of having to make do with fewer units of energy. Therefore, the different response of the economy to 

the recent energy price increases does not appear to be related to the difference in the economy’s energy intensity.

Monetary Policy

Improvements in monetary policy over the years are a 

major reason that the economy is weathering the recent 

rise in energy prices relatively well. In essence, policymakers have learned how to better manage monetary policy over the past two decades. 

With the earlier increases in energy prices, monetary policy strongly affected the immediate response of consumer 

and investment spending. Indeed, it is widely believed 

that the deep recession of 1973 to 1975 and the backto-back recessions of 1980 and 1981 to 1982 were caused 

not by the energy price shocks as such but by monetary 

policy.3

 During the 1973–1974 period and again from 

1979 to 1981, the Federal Reserve tightened policy 

sharply to curtail inflation, which had been festering for 

years before oil prices increased. The rise in short-term 

interest rates caused the economy to contract and unem2. Since the late 1980s, the economies of Eastern Europe, Russia, 

and China have become much more market oriented, and many 

previously state-owned industries in Europe have been denationalized. See Alan S. Blinder, “How the Economy Came to Resemble 

the Model,” Business Economics (January 2000).

1970 1975 1980 1985 1990 1995 2000 2005

100

200

300

400

500

1,000

0

3. See J. Bradford De Long, “America’s Peacetime Inflation: The 

1970s,” in Christina D. Romer and David H. Romer, eds., Reducing Inflation: Motivation and Strategy (Chicago: University of Chicago Press, 1997), pp. 247–276; Robert B. Barsky and Lutz 

Kilian, Do We Really Know That Oil Caused the Great Stagflation? 

A Monetary Alternative, Working Paper No. 8389 (Cambridge, 

Mass.: National Bureau of Economic Research, July 2001), available at http://papers.nber.org/papers/w8389; and Ben Bernanke, 

Mark Gertler, and Mark Watson, “Systematic Monetary Policy 

and the Effects of Oil Price Shocks,” Brookings Papers on Economic 

Activity, no. 1 (1997) pp. 91–142. 
CHAPTER THREE WHY HAVE THE NEGATIVE EFFECTS OF RECENT ENERGY PRICE INCREASES BEEN SMALLER THAN THOSE IN THE 1970S? 21

Figure 3-7.

Energy Consumption and 

Gross Domestic Product

Sources: Congressional Budget Office; Department of Commerce, 

Bureau of Economic Analysis; Department of Energy, 

Energy Information Administration. 

Note: Real gross domestic product is in billions of chained 2000 

dollars.

ployment to increase. The tightening of monetary policy 

in those years was partly spurred by the oil price shocks, 

but the inability of monetary policy to control inflation 

in the years leading up to those shocks and the need to 

tighten policy thereafter were the underlying cause of the 

recessions of 1973 to 1975 and the early 1980s.4

By the end of the 1990s, however, the Federal Reserve 

had earned credibility in fighting inflation, especially 

with three episodes of tight monetary policy: 

B From 1980 to 1982, when it tightened policy (in order to quash inflation) to such a degree that a deep recession resulted, driving the unemployment rate to 

almost 11 percent; 

B From 1988 to 1989, when the central bank raised the 

federal funds rate by about 3 percentage points in anticipation of inflation, even though core inflation had 

been relatively steady; and 

B In 1994, when the Federal Reserve raised the federal 

funds rate even before inflation started to increase, out 

of concern that its monetary policy had been too stimulative in previous years. 

The Federal Reserve’s apparent willingness to risk recessions to forestall inflation—combined with success in reducing inflation and keeping it low—means that households, businesses, and investors are less likely to anticipate 

an increase in inflation than they would have been if the 

Federal Reserve had not established that track record. 

The credibility of the Federal Reserve affects how households and firms respond to an increase in energy prices. 

Lack of credibility can cause higher and more-persistent 

inflation as well as a larger negative impact on GDP. If 

workers anticipate higher inflation, they will try to incorporate those expectations into wage agreements, and 

businesses will set prices on the basis of higher anticipated 

costs in the future. That behavior can lead to a “wage–

price spiral,” in which the initial increase in the level of 

prices (which, by itself, is only a one-time rise in inflation) is perpetuated as a higher growth rate of prices for 

some time. The Chairman of the Federal Reserve Board 

recently stated that one reason that energy price increases 

1970 1975 1980 1985 1990 1995 2000 2005

8

6

4

2

0

1970 1975 1980 1985 1990 1995 2000 2005

10

8

6

4

2

0

Percent

Thousands of British thermal units

Petroleum

Natural Gas

Energy Consumption per Dollar

of Real GDP, 1970 to 2005

Nominal Petroleum Spending as a Percentage

of GDP, 1973 to the First Quarter of 2006

4. See Richard Clarida, Jordi Gali, and Mark Gertler, “Monetary 

Policy Rules and Macroeconomic Stability: Evidence and Some 

Theory,” Quarterly Journal of Economics, vol. 115, no. 1 (February 

2000).
22 THE ECONOMIC EFFECTS OF RECENT INCREASES IN ENERGY PRICES

did more damage to the economy in the past than they 

have recently is that wage–price spirals made it more difficult for the Federal Reserve to manage inflation in the 

1970s.5

Uncertainty about inflation has an additional negative effect: consumers and businesses are less confident about 

the ability of the economy to avoid a recession. Concern 

about a future recession encourages households and firms 

to postpone some spending, thus weakening the economy. Therefore, by itself, the establishment of credibility 

by the Federal Reserve can mitigate the adverse impact of 

an energy price increase. 

The Flexibility of the Economy

The flexibility of today’s economy is also often cited as a 

reason that the recent oil price increases did not have 

large negative effects.6

 Four major aspects of the U.S. 

economy—government regulatory policy, industrial behavior, changes in energy markets, and developments in 

financial markets—have evolved to produce an economy 

that appears to be much more resilient to price shocks 

now than it was before the 1980s. 

Flexibility refers to an economy’s ability to adjust to 

changes—particularly sharp ones—in the relative availability of goods and services. In a market economy, flexibility stems from the speed with which prices can shift to 

reflect new relationships of relative scarcity. When prices 

for a given commodity rise, households and businesses 

will make adjustments to conserve on the use of that 

commodity (and any goods or services produced with it), 

focusing their use on areas with the most value to them. 

In addition, firms will try to increase production of the 

commodity. If prices do not reflect relative scarcities, 

however, producers and consumers will not receive accurate signals. There will be little effort to produce more of 

the commodity, and reductions in its use will be less 

likely to be concentrated in areas that are the least valued. 

Consequently, the need to consume less of the commodity will be more disruptive to the economy. 

The increased flexibility of the U.S. economy has probably played a significant role in the aforementioned development of the Federal Reserve’s credibility. In fact, the effects of that credibility are difficult to separate from the 

possible effects of greater economic flexibility. The shortrun trade-off between inflation and unemployment depends in large part on the underlying structure of the 

economy, and the recent success of the Federal Reserve’s 

policies is probably closely related to structural changes in 

the economy that have moderated that trade-off. The 

structural changes in the economy may have made it 

much easier to maintain low inflation in the face of a supply shock. Monetary policy appears to have fared better 

in part because it was applied to an economy that was intrinsically easier to manage. 

Less Economic Regulation

Some government regulations introduce rigidities that 

make the macroeconomy less able to respond to sharp 

changes in relative prices. In so doing, they make it 

harder for monetary policy to control inflation and lead 

to greater losses in output than if those regulations were 

not in effect. 

Regulation of the economy was generally more pervasive 

in the past than it is now. In particular, two areas of economic regulation in the 1970s—petroleum markets and 

housing finance—increased the damage to the economy 

when energy prices rose. Restrictions in those areas have 

since been altered; in addition, many other economic regulations have been modified or eliminated since the late 

1970s, and those changes may have helped to partially insulate today’s economy from energy price shocks. Examples of such alterations are the deregulation of the transportation sector in the 1970s and 1980s and changes in 

financial regulations over the past 25 years.

Petroleum Regulations. Problems in energy market regulation in the 1970s began when the government instituted wage and price controls. Those problems were 

greatly exacerbated by the 1973 enactment of the Emergency Petroleum Allocation Act (EPAA). 

To help independent refiners—who had been hurt by the 

wage and price controls—the EPAA provided for mandatory allocation of petroleum. It required large oil companies to give independent refiners shares of oil proportion5. Ben Bernanke, “The Benefits of Price Stability” (remarks at the 

Center for Economic Policy Studies, Princeton, N.J., February 24, 

2006), available at www.federalreserve.gov/boarddocs/speeches/

2006/200602242/default.htm.

6. See Alan Greenspan, “Energy” (remarks to the Japan Business 

Federation, Japan Chamber of Commerce and Industry, and 

Japan Association of Corporate Executives, Tokyo, October 17, 

2005), available at www.federalreserve.gov/boarddocs/speeches/

2005/20051017/default.htm.
CHAPTER THREE WHY HAVE THE NEGATIVE EFFECTS OF RECENT ENERGY PRICE INCREASES BEEN SMALLER THAN THOSE IN THE 1970S? 23

ate to those they had received in 1972. In addition, the 

law created a two-tier system of price controls on U.S. 

crude oil. “Old” oil was tightly controlled at low prices, 

whereas “newly discovered” oil was uncontrolled. That 

system was intended to encourage new production while 

keeping established sources of oil from reaping windfall 

profits that were thought to be undeserved. Refineries 

that had access to old oil had a financial advantage, and a 

system of “entitlements” was put in place to try to force 

all refiners to have the same feedstock costs. In sum, the 

EPAA overrode market mechanisms in an effort to distribute scarce supplies to independent refiners and to insulate energy users from price increases that were not related to higher production costs—and that therefore were 

considered unjustified at best and “price gouging” at 

worst.7

The regulations on the energy sector depressed economic 

growth and ultimately exacerbated the rise in energy 

prices (and inflation overall). A major unintended effect 

of the two-tier system was to encourage owners of “old” 

oil to withhold some of their oil from the market in the 

expectation that they would be able to sell it later at 

higher prices once the controls had expired. Data on domestic production, consumption, and imports for the period show that U.S. oil production fell in 1974, even 

though market prices for petroleum were much higher. If 

energy markets had not been regulated, more oil would 

have been made available, dampening the increase in the 

international price of oil. 

The domestic price of gasoline was also artificially depressed relative to the world price of petroleum. If gasoline prices had been allowed to rise to balance supply and 

demand, consumers would have devoted gasoline to its 

most highly valued uses, and more gasoline would have 

been supplied. 

Many efforts were made between 1973 and 1978 to alter 

the EPAA, and legislation was put in place to gradually 

deregulate much of the energy sector. Nevertheless, the 

bulk of the controls were still in effect in 1979, when a 

second oil price shock occurred. As before, the distorting 

effects of the oil regulations created problems in 1979 

and 1980. Not until 1981 were the controls on oil markets essentially eliminated.

Regulations That Affected Housing. Changes in regulations on housing finance since the 1970s have helped insulate today’s economy from energy price increases. In the 

1970s’ environment of rising inflation and interest rates, 

regulations on the mortgage market that had been in effect for many years—Regulation Q and usury laws for 

residential mortgages—turned out to be damaging to the 

economy.8 Regulation Q set ceilings on the interest rates 

that most financial institutions could pay on various 

types of deposits. When market rates exceeded those ceilings, the growth of deposits at commercial banks and savings and loan institutions slowed (a process known as disintermediation). The result was a shortage of mortgage 

financing in the housing market. Other lenders were dissuaded from entering that market because state usury 

laws and federal regulations restricted mortgage pricing 

and limited the returns on mortgages. 

Because of those regulations, the effort to fight inflation 

by raising interest rates caused a shift in funds from depository institutions to money market instruments and 

put binding constraints on mortgage rates. Mortgage financing dried up, and home sales and home building collapsed. Such effects exacerbated the 1973–1975, 1980, 

and 1981–1982 recessions and contributed to the overall 

volatility of GDP throughout the 1970s and early 1980s. 

The large drop in housing activity during the 1973–1975 

recession was not attributable entirely to the effects of 

Regulation Q. The rise in interest rates would probably 

have slowed housing activity in any event, and as recessions deepen, housing declines for reasons other than

financing problems. However, by inhibiting housing 

activity even before the onset of the recession—singlefamily housing starts were already 6 percent lower than in 

the previous year by the second quarter of 1973—

7. Franklin Tugwell, The Energy Crisis and the American Political 

Economy: Politics and Markets in the Management of Natural 

Resources (Stanford, Calif.: Stanford University Press, 1988).

8. See Philip K. Robins, “The Effects of State Usury Ceilings on Single Family Homebuilding,” Journal of Finance, vol. 29, no. 1 

(March 1974), pp. 227–235; and R. Alton Gilbert, “Requiem for 

Regulation Q: What It Did and Why It Passed Away,” Review, 

Federal Reserve Bank of St. Louis (February 1986), pp. 22–37, 

available at http://research.stlouisfed.org/publications/review/

past/1986/.
24 THE ECONOMIC EFFECTS OF RECENT INCREASES IN ENERGY PRICES

Figure 3-8.

Single-Family Housing Starts, 

1965 to the First Quarter of 2006

(Millions)

Sources: Congressional Budget Office; Department of Commerce, 

Bureau of the Census.

Regulation Q weakened the economy in the months before the oil price shock. It also made home building extremely sensitive to interest rates. Single-family housing 

starts dropped by over 20 percent in 1974 and continued 

to decline well into 1975 (see Figure 3-8). 

Recognizing the harmful effects of Regulation Q, policymakers modified it in the late 1970s. But when high inflation and tight monetary policy pushed interest rates 

into double digits in 1979 and 1980, the growth of deposits again slowed, and residential investment again collapsed. As in 1973 and 1974, surging interest rates 

pushed housing investment down faster than they would 

have in the absence of regulations, and thus the regulations exacerbated the macroeconomic response to the oil 

shock.

In 1980, lawmakers enacted the Depository Institutions 

Deregulation and Monetary Control Act, which initiated 

a general phaseout of Regulation Q. Interest ceilings on 

time and savings deposits were eliminated by 1986. That 

change helped make residential investment less sensitive 

to movements in interest rates and thereby reduced volatility in the housing market. 

Other Regulations. The deregulation of the transportation sector and changes in financial regulations may also 

have improved the flexibility of the economy over the 

past 25 years. 

Before the late 1970s, the Civil Aeronautics Board regulated the pricing and route structure of the airline industry. Carriers initially favored those controls because they 

discouraged competition, but the regulations inhibited 

airlines’ ability to allocate resources properly. Federal control over airfares and routes was greatly reduced by the 

early 1980s, and airlines were able to operate more efficiently by adjusting their fares according to market 

forces.9

The trucking industry experienced a similar improvement in efficiency when it was deregulated in the 1980s. 

Before deregulation, the Interstate Commerce Commission controlled shipping rates and restricted firms from 

entering markets. With the enactment of the Motor Carrier Act in 1980, the industry became more competitive. 

As in the airline industry, prices began to reflect actual 

market conditions. As restrictions on market entry and 

route structure eased, the number of licensed trucking 

firms increased, delivery times improved, and inventory 

costs fell. 

Changes in financial regulations may also have improved 

the resilience of the economy. Since the 1970s, restrictions on banks establishing branches out of state have 

been eliminated, risk-based capital requirements have 

been implemented, and the supervision of banks has been 

enhanced. Financial deregulation made it possible for 

banks to consolidate and to become larger, more diverse, 

and stronger financially. Capital ratios and earnings in the 

banking industry were high before the recent increase in 

energy prices, and that strength resulted in a banking industry that could “cushion” the adverse effects of the energy price shock.10

1965 1975 1985 1995 2005

2.0

1.5

1.0

0.5

0

9. See Steven Morrison and Clifford Winston, The Economic Effects 

of Airline Deregulation (Washington, D.C.: Brookings Institution, 

1986), pp. 11–15. 

10. See Timothy F. Geithner, “Perspectives on the U.S. Financial System” (remarks to the Economic Club of New York, May 27, 

2004), available at www.ny.frb.org/newsevents/speeches/2004/

gei040527.html. 
CHAPTER THREE WHY HAVE THE NEGATIVE EFFECTS OF RECENT ENERGY PRICE INCREASES BEEN SMALLER THAN THOSE IN THE 1970S? 25

Changes in Competition and Industrial Behavior

Various developments appear to have increased the competitive pressure on companies and encouraged them to 

be more responsive to changes in relative prices than they 

were in the 1970s. Those developments include the expansion of international trade, the growth of information 

technology and the creation of the Internet, and changes 

in management behavior. Now, when energy prices rise, 

firms may be quicker both to try to conserve energy and 

to pass along the higher costs to their customers. As a result, prices more quickly and accurately reflect the relative 

scarcity and relative value of goods and services.

Competition from abroad has probably had a much bigger impact on the behavior of goods prices in the United 

States in the past 15 or 20 years than it did earlier. Decreases in international communication and shipping 

costs, reductions in tariffs, and the expansion of marketoriented economies around the world have increased international competition and caused the prices of goods to 

be more responsive to changes in relative prices and other 

market conditions.11

Advances in information technology have also contributed to the flexibility of the U.S. economy. Computers 

and communications equipment have become cheaper 

and more powerful through developments in semiconductor technology. Those developments have allowed 

memory chips and microprocessors in computers, satellites, and other products to manipulate data more efficiently, thereby reducing transaction costs and facilitating 

coordination among firms.12

A prime example is the Internet. In addition to improving communication and generally decreasing the cost of 

business, it has enhanced the responsiveness of prices to 

changes in costs and demand by giving buyers and sellers 

more information relatively inexpensively. As lower 

search costs and more effective targeting strengthen competition, price “stickiness” (resistance to change) is probably reduced.13

Other changes that may have made the economy more 

flexible over the past 25 years are shifts in the attitudes 

and goals of corporate managers and greater reliance on 

capital markets instead of managers to allocate investment funds. Those explanations are speculative, but various developments that affected corporate governance—

including the wave of takeovers during the 1980s—may 

have forced managers to focus more on maximizing profits than on maximizing revenues (or other such performance measures). That change has probably encouraged 

managers to respond more rapidly to developments in 

their market. In addition, the increasing and unremitting 

pressure to keep a firm profitable in the face of deregulation, rapid shifts in technology, globalization, and the 

heightened pace of innovation and competition from 

start-up companies may have driven managers to be less 

complacent, more attuned to markets, and more concerned about enhancing productivity and managing costs 

than they were before.

Structural changes in industrial and labor markets may 

have contributed to the reduction of wage–price spirals. 

As mentioned above, the increasing credibility of monetary policy probably reduced workers’ and managers’ expectations that a price shock would be perpetuated as 

higher inflation. But structural changes, such as the increase in competition and shifts in industrial behavior, 

also helped keep wage–price spirals from developing by 

reducing the bargaining power of unions and the market 

power of firms.

Developments in Energy Markets

Since the 1970s, new energy markets and institutions 

have arisen that help large sellers and buyers of petroleum 

manage uncertainty. Futures markets and other pricing 

institutions reduce the need for major buyers of petroleum or petroleum products to stockpile physical supplies 

to ensure against shortages. The resulting decrease in 

changes in inventory dampens the effect of a sharp price 

increase on the economy. 

The futures market for petroleum matches people who 

will need petroleum in the future with people who will 

11. See Donald L. Kohn, “The Effects of Globalization on Inflation 

and Their Implications for Monetary Policy” (remarks at the Federal Reserve Bank of Boston’s 51st Economic Conference, “Global 

Imbalances: As Giants Evolve,” Chatham, Mass., June 16, 2006), 

available at www.bos.frb.org/economic/conf/conf51/papers/

kohn.pdf.

12. See Dale W. Jorgenson, “Information Technology and the U.S. 

Economy,” American Economic Review, vol. 91, no. 1 (March 

2001).

13. Erik Brynjolfsson and Michael D. Smith, “Frictionless Commerce? A Comparison of Internet and Conventional Retailers,” 

Management Science, vol. 46, no. 4 (April 2000).
26 THE ECONOMIC EFFECTS OF RECENT INCREASES IN ENERGY PRICES

have petroleum to sell in the future. The buyer and seller 

enter into a contract that requires the seller to deliver the 

petroleum, and the buyer to accept it, at a specified price 

a few months, a year, or longer in the future. Because oil 

producers and customers who use futures markets face 

less uncertainty about the price and quantity of oil they 

will be able to sell or buy in the future, they are more 

willing to reduce their stock of inventory (or at least feel 

less need to add to that stock) during a shortage.14

The effects of futures markets can be seen in the differing 

behavior of inventory stocks during the various oil price 

shocks of the past 30 years. During the 1970s, inventories 

grew when markets were disrupted. During the 1990–

1991 Persian Gulf War and the recent increase in energy 

prices, by contrast, inventories remained relatively stable. 

Developments in Financial Markets and Institutions

Financial innovations since the 1970s have also had a role 

in making the economy more flexible. Securitization (the 

conversion of a cash flow into securities), credit derivatives (financial instruments designed to transfer credit 

risk from one party to another), and interest-rate swaps 

(in which two entities exchange a series of payments calculated using different interest rates) have provided an alternative to bank lending, broadened the financialintermediation mechanism between borrowers and 

lenders, and enhanced risk management.

Financial innovations have also improved households’ access to credit and lowered the cost of credit since the 

1970s, and they probably played a role in the way households responded to the most recent energy price rise. Numerous improvements in mortgage finance, including 

home-equity lines of credit and easier refinancing, encouraged households to use the equity in their homes to 

maintain their spending when the growth of household 

real income slowed.

Those innovations, together with changes in financial 

regulation, appear to have improved the resiliency of the 

financial system by spreading the risk of default more 

widely and efficiently. As the former Chairman of the 

Federal Reserve Board noted, “Deregulation and the 

newer information technologies have joined, in the 

United States and elsewhere, to advance flexibility in the 

financial sector. Financial stability may turn out to have 

been the most important contributor to the evident significant gains in economic stability over the past two decades.”15

14. See Congressional Budget Office, Rethinking Emergency Energy 

Policy (December 1994).

15. Alan Greenspan, “Economic Flexibility” (remarks to the annual 

meeting of the National Association for Business Economics, Chicago, September 27, 2005), available at www.federalreserve.gov/

boarddocs/speeches/2005/20050927/default.htm.