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Who’s Afraid of a Big Bad Oil Shock? 

William Nordhaus 

Yale University 

Prepared for Brookings Panel on Economic Activity 

Special Anniversary Edition 

September 2007 

When the U.S. invaded Iraq in March 2003, many economists feared that 

the war would lead to a sharp decline in Iraqi oil production, a spike in oil prices, 

and a woeful economy that would follow the scripts of the oil shocks of 1973, 

1978, and 1990. There was in fact a moderate decline in world oil production, and 

real oil prices increased from $20 in 2001:4 to $62 in 2006:3. But the ailments 

associated with earlier oil-price increases did not appear. Instead, output 

continued to grow rapidly, inflation was moderate, unemployment fell, 

consumers remained happy, and productivity grew at close to its postwar norm.1

 Macroeconomists would be out of business were there no surprises. The 

business of this paper is to inquire into the explanations for the surprising oil 

non-crisis of the early 2000s. The robustness of the economy following the latest 

oil shock can perhaps be seen in the context of one of the most important 

developments in all of macroeconomics, the Great Moderation. This little-noticed 

theory holds that the economy has shown much less volatility of inflation, 

unemployment, and output growth since World War II. (See particularly Stock 

                                                           

1 The data and sources as well as elaboration of the quantitative statements in the text 

are contained in a set of accompanying notes, “Notes on Data and Methods for ‘Who’s 

Afraid of the Big Bad Oil Shock?’,” August 27, 2007, available on the web at 

http://www.econ.yale.edu/~nordhaus/homepage/Data_BPEA_20072_v2.pdf. 

(Version is Big_Bad_Oil_Shock_Meeting.doc.) 
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and Watson [2002].) Perhaps the moderated response of the economy to the latest 

oil shock is part of the declining volatility of the overall economy. 

 While much has been written about the macroeconomic impacts of price 

shocks, little analysis is available on the impact of the most recent shock. The 

most comprehensive study is a preliminary paper by Blanchard and Gali [2007]. 

Most research focuses on the role of monetary policy and inflation dynamics in 

the post-shock periods. There seems to be no consensus as to whether the 

macroeconomic fear of oil-price shocks continues to be warranted. 

 Shocks past and present

 It will be useful to present the basic data on oil shocks past and present, 

shown in Table 1. This table shows the major data on the behavior of the 

economy following the four oil-price shocks after the 1973 Arab-Israeli war, the 

1978 Iranian revolution, the 1990 Iraqi invasion of Kuwait, and the 2002 run-up 

to the American war in Iraq. The first date shown is the dating of the oil shock, 

while the second date is period when oil prices peaked. 

 The first numerical column shows the percentage increase in the real price 

of oil. (The oil price shown here is the average refiner acquisition cost of crude 

oil, except during the period of price controls, when it is the import cost. The 

price is deflated by the price index of personal consumption expenditures.) The 

most recent shock involved a real oil-price increase of 125 percent, which about 

as large as the average of the 1970s oil-price increases. The 1990 increase was 

smaller and short-lived, while the most recent increase was more gradual and 

therefore perhaps less of a pure shock. 

 We next examine the macroeconomic reactions to the oil shocks. This is at 

this point a simple before-and-after look at the data and clearly cannot establish 

causality. It does provide an initial look at the economic conditions after the oil 

shocks. 
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The next two columns show the macroeconomic response in terms of the 

unemployment rate and the percentage output gap. (The gap, or perhaps more 

accurately the capacity utilization ratio, is the ratio of actual to potential output.) 

This illustrates that latest shock did not have the accustomed recessionary impact 

on the economy. The unemployment rate fell by slightly more than 1 percentage 

point, while the output gap increased slightly. The most recent episode contrasts 

sharply with the shocks of the 1970s, when the unemployment rate rose between 

2 and 4 percentage points, and the output gap declined sharply. 

 While the latest oil shock did not lead to a recession, the impacts on 

inflation and productivity were similar to those in the shocks of the 1970s. 

Inflation measured by either the PCE price index or the CPI rose about 11⁄2 

percentage points, which is, we will see shortly, pretty much what is in line with 

the direct impact of the rise in energy prices. The most recent spurt in inflation 

was much less than the sharp rise in the 1970s. Additionally, the recent oil-price 

increase was followed by a significant decline in productivity growth of 1.5 

percentage points. In this respect, the experience following the recent oil shock 

parallels that of the 1970s, where the decline in productivity was only marginally 

larger. 

The summary message of Table 1 is that the most recent oil shock is more 

similar to earlier shocks than might first appear. Inflation and productivity 

behaved similarly to earlier shocks. The major difference is that the oil shock was 

followed by a continued economic expansion rather than a recession. 

Why Are Oil-price Shocks Contractionary?

The first challenge in studying oil-price shocks is to understand why they 

might reduce real output in the first place. There are basically two sets of 

reasons: effects on productivity and effects on aggregate demand. 
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 The effect of energy-price shocks on productivity involves substitution of 

other factors for energy in response to higher energy prices. In a world with 

exogenous technological change, there will actually be no response of multifactor 

productivity to price changes, for the response is only substitution along a given 

technological frontier. However, if we examine partial productivity measures, 

such as labor productivity, then there might be a response, such as when labor is 

substituted for energy. 

 It is easy to forget how small the substitution response would be. To begin 

with, in a full-employment world, there would be no productivity response in 

the short run until substitution occurs. None, as in zero. If people continue 

driving and flying and using the old capital equipment at the same rate as before 

the price shock, all inputs and outputs would be identical, and there would 

consequently be no productivity impact. 

In a simplified one-product neoclassical world, the productivity response 

to an oil-price change is approximately proportional to (the elasticity of output 

with respect to oil) times (the price-elasticity of demand for oil) times (the 

logarithmic change in the price of oil). (You can substitute energy for oil in this 

equation to get the energy-price impact.) An illustrative calculation will indicate 

how small the substitution-productivity effect would be. We estimate that the 

one-year price-elasticity of demand for crude oil in the U.S. for the period 

1970:Q1 to 1995:Q4 was -0.04 (+ 0.01) while the ten-year elasticity was -0.24. 

Taking the average share of oil in GDP for this period of 3 percent, the 

productivity effect of a doubling of real oil prices would be a decrease of 0.11 

percent per year and 0.046 percent per year for a one-year and ten-year horizon, 

respectively. This is at least ten times smaller than the productivity impact 

shown in Table 1. 

These calculations indicate that we should not look to impacts on 

productivity and potential output as the mechanism for understanding output 

responses to energy-price shocks. They also remind us that there is no 
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fundamental economic reason why energy-price shocks should lead to recession 

and unemployment. 

A more likely mechanism is that price shocks work through aggregate 

demand. There are actually two important ways that price shocks can affect 

aggregate demand. A first is through monetary policy: Higher energy prices 

produce inflation, which may lead the Federal Reserve to tighten money and 

slow the economy. (This is the mechanism that is argued for in Bernanke, Gertler, 

and Watson [1997].) We can think of this process in terms of the Taylor Rule, 

which holds that the Federal funds rate is a function of the deviation of inflation 

and unemployment from their targets. As energy-price increases boost 

consumer-price inflation, this would trigger a monetary tightening and thereby 

lead to a contractionary impact of higher energy prices. 

The contractionary effect of monetary policy will clearly depend upon 

whether and how closely the Fed follows some variant of the Taylor Rule. In the 

late 1970s, the Fed, like Molière’s character who spoke prose without knowing it, 

reacted powerfully to energy-price driven inflation, and this is one cogent 

explanation of the depth of the recession following the 1978 oil shock. 

However, in recent years, the Fed has emphasized core PCE inflation, 

which excludes the direct effect of energy-price (as well as food-price) increases – 

call this the “core Taylor Rule.” If the Fed follows the core Taylor rule, then this 

second contractionary mechanism would not operate until and unless energy 

prices get transmitted into a further round of price or wage increases. (As a 

technical aside, core inflation excludes energy-price increases that get into 

consumer goods and services indirectly through business purchases of energy; 

examples are airfares and apartment rents. So the total impact of energy prices 

on consumer prices with 100 percent pass-through will exceed the direct impacts 

that are removed in calculating the core inflation rates. A rough estimate is that 

the total impact on consumer prices is about 1.8 times the direct effect.) 
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There is some evidence that the Fed behaves as it speaks. If we estimate a 

rolling regression Taylor Rule with separate terms for core PCE inflation and 

energy PCE inflation, we see that the coefficient on energy inflation was 

essentially zero in the 1990-2007 period. By contrast, in earlier periods, 

particularly in the 1970s, the reaction of the Federal funds rate to energy inflation 

was very sharp. This would suggest that oil prices are less contractionary today 

because monetary policy accommodates one-time shocks to energy prices. 

The second mechanism, and one that was emphasized in the 1970s by 

members of the Brookings Panel, is “oil price as tax increase.” The idea is that an 

increase in oil prices, through the income effect, lowers real disposable income of 

consumers and thereby lowers real consumption. The logic is that the marginal 

propensity to consumer of energy buyers is much higher than that of energy 

sellers. Buyers tend to be consumers, perhaps even low-income consumers 

because of the regressive nature of energy spending, and therefore have high 

MPCs. 

The seller side is more complex. An increase in oil prices leads to higher 

profits. The domestic profits would flow largely to corporations, which (at least 

in the old days when capital was taxed) had a high marginal tax rate. A 

substantial fraction of the post-tax corporate profits would either be saved in 

higher retained earnings or flow to high-income households, both of which 

would have low MPCs. Similarly, higher foreign revenues flowing to OPEC tend 

to be saved, and any additional spending would only marginally be on U.S. 

production. Going through this chain of spending, it would be plausible to argue 

that the marginal expenditure on U.S. production from oil profits might be close 

to zero in the short run. The net effect of a permanent oil-price increase might 

therefore be almost as powerful as a permanent tax increase. 
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Measuring Oil Shocks

The second challenge in studying oil-price shocks is to determine an 

appropriate shock variable. The standard approach in studies of oil prices and 

the macroeconomy has been to use either nominal or real oil prices (see Hamilton 

[1983] and Blanchard and Gali [2007] as examples). This approach is clearly 

defective, as it does not scale oil prices for their economic importance. 

It is useful to go back to first principles in defining a shock variable. All 

three of the mechanisms discussed in the last section would point to the overall 

share of oil or energy as the relevant variable for measuring the effect of a price 

shock. In the production function approach, the share of oil or energy in income 

(or the production elasticity) will be the key variable. 

Similarly, in the oil-price-as tax-increase theory, the impact of changing 

prices will come through the effect on real income – that is, through the standard 

income effect. We follow this route in defining our shock variable. This would 

be measured by the value of purchases times the change in the price. That is, the 

income effect = (PX) ΔP, where P = price, X= quantity, PX = value of 

consumption, and the change is over θ periods. If we want to consider the 

importance relative to the economy, we might then divide by nominal GDP, 

which provides a first definition of the “oil-shock variable” at time t: 

(1) OilShock(t; θ) = {P(t)X(t) ln[P(t)/P(t-θ)]}/GDP(t)

For this definition, P is the nominal price of crude oil and X is the total domestic 

consumption of crude oil. 

This definition is limited because it considers only oil. We therefore define 

a second variable which is an “energy-shock variable.” This is conceptually the 

same as the oil-shock variable but uses the price and quantity of personal 

consumption expenditures on energy products (primarily gasoline, electricity, 

and heating fuels). For this second shock variable, we use personal consumption 

expenditures as the denominator. The advantage of the energy-shock variable is 
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that it is more inclusive and considers the impact on consumers. The 

disadvantage is that it omits second-round effects, such as the effect of oil prices 

on jet fuel and thence on air fares. 

Figure 1 shows cumulative measures of the energy- and oil-shock 

variables. We show the cumulative totals because the shock variable will differ 

depending upon the length of the differencing period. Table 2 shows the changes 

in the scaled shock variables over the shock periods for each episode. These are 

calculated as a rate per year to reflect the fact that the period of shock varied 

across shock periods. 

In terms of the total size of the shock, the 2002-2006 shock was close to the 

average of the 1970 shocks. However, the oil shocks of the 1970s had a 

completely different shape than that of 2002-2006 period in that the earlier ones 

were very sharp, while that of the 2000s was much more gradual. If we consider 

the oil-shock variable at an annual rate, then the shock per year was 2.1% for 

1973-75, 2.4% for 1978-80, but only 0.7% for 2002-2006. The rates were roughly 

similarly proportioned for the energy-shock variables. 

The historical context and shape of the energy and oil shocks suggest that 

those of the 1970s might have a far more powerful economic impact. The 1970s 

shocks were dislocations that changed our view of energy and resources in a 

fundamental way. Given the historical stability of oil prices before the fall of 

1973, the changes that ensued were large-sigma events, similar in psychological 

effect to the collapse of the World Trade Towers or Hurricane Katrina. For 

example, the largest four-quarter change in the real oil price between 1950 and 

1973 was 10 percent. In the next two years, the change was as high as 160 

percent. My recollection is that no serious forecaster in 1972 foresaw anything 

approaching a five-fold increase in the real price of oil by the end of the decade. 

By contrast, the oil-price increase of the 2000s was large, but not outside 

the range of reasonable pessimism. Indeed, George Perry’s study of the economic 

effects of terrorist events indicated that $75 per barrel oil was a “worse case” and 
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not even the “worst case” (Perry [2001]). My study of the economic effects of the 

war in Iraq also suggested an oil-price spike of $75 per barrel for my high case, 

declining as the war wound down (Nordhaus [2002]). 

To summarize, when we construct a scaled oil-shock and energy-shock 

variable, we see that the oil and energy shock of the 2000 has a cumulative 

economic effect that is similar to that of the 1970s shocks. However, the latest 

shock was much more gradual and was not unthinkably large to market 

participants. 

Mechanisms for declining impact of oil shocks

It is worth pausing to consider why oil shocks might have a smaller impact 

on the economy today than in earlier periods. We can preliminarily consider 

three reasons: smaller shocks, smaller multipliers, and other forces. (Many of 

these issues were originally investigated in Hamilton [1983].) 

A first reason why oil-price shocks might have a smaller impact is that the 

shocks are smaller. As earlier sections indicated, this can account for a smaller 

macroeconomic response but not for an economic expansion during the 2002-

2006 period. 

A second reason for a smaller impact is that the transmission mechanism 

has progressively tended to moderate the macroeconomic impact of shocks. 

Under the classical Frischian view of the economy, we distinguish exogenous 

and policy shocks (in which category the first reason lies) from the complicated 

non-linear stochastic dynamic system which takes shocks and generates 

endogenous variables like unemployment, prices, and output. In this second 

approach, a given variability of exogenous or policy variables such as oil prices 

would lead to lower variability of output. In the simplest macroeconomic 

framework, the oil-price multiplier on output is smaller. 
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A third reason for a smaller impact is that other variables might have 

reinforced the contractionary and inflationary impacts of oil prices in the 1970s 

while they tended to offset those impacts in the 2000s. Economic histories of the 

1970s point to other shocks such as commodity shortages, poor grain harvests, 

political business cycles, collapse of the Bretton Woods system, disappearing 

anchovies, and an army of plagues that reinforced the inflationary impact of the 

1973 shock, while the anti-inflation wars of the 1979-82 period (in part motivated 

by the 1978 shock) surely reinforced the contractionary impact of the 1978 shock. 

Note again that the story of the oil-price shocks runs parallel to the 

explanation of the Great Moderation. In explaining the declining volatility of 

output and inflation, we would look to some combination of these three factors. 

The trajectory of shocks and responses

I next take a closer look at the pattern of shocks and responses for the three 

major episodes. For this, I examine the time series of inflation and output along 

with the cumulative energy and oil shocks. For these comparisons, I plot the 

cumulative oil and energy-shock variables just described along with the 

trajectories of output or inflation. 

Figure 2 shows the time series on the price shock variables along with 

output. For this purpose, we use as the output variable the ratio of real output to 

potential real output as defined by the Congressional Budget Office. I have 

normalized the variables to be zero on the shock date. Therefore, the plot shows 

the cumulative change since the shock date. For example, output declined 

relative to potential by 7.7 percent in 1975:2, while the size of the cumulative 

energy and oil shocks were 1.2 and 3.7 percent of PCE and GDP in that period. 

Figure 2 shows the anomaly for the 2000s. Whereas output paralleled the 

(negative) shocks of the 1970s, the relationship reversed in the 2000s. The sample 
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size of shocks is obviously pathetically small, but it is clear that the earlier 

relationships did not hold. 

Figure 3 shows the same graph for the energy shocks and inflation. For 

this graph, we use both the CPI (which policymakers tended to follow in the 

1970s) and the PCE price index. The relationship between inflation and the price 

shocks is clearly positive for each of the three periods. 

Looking closer, however, we see some interesting factors. Perhaps the 

most interesting relationship is between the energy-price shock and PCE 

inflation. By construction, if the only factor changing during the period was 

energy-price inflation, the two lines would coincide (almost) exactly. This is 

because the PCE price index is a superlative index that uses virtually the same 

construction as our energy-price shock variable. (There is actually a small thirdorder difference because the PCE is a Fisher index while our construction is a 

Törnqvist index, but the difference is trivially small.) 

In the first period, the PCE shock was about three times the energy-price 

shock. This indicates that other factors (imports, other commodities, and wages) 

operated to reinforce the energy-price shock in the 1973-75 period. Note as well 

that the CPI bias was small in this period. In the second period, virtually all of 

the rise in PCE inflation can be accounted for by energy-price inflation. Note 

however that the CPI in the 1978-81 period rose much more rapidly than the PCE 

price index, partially because of flawed construction from housing and the 

Laspeyres structure. 

In the third period, the contribution of the energy-price shock was about 

one-half times larger than PCE inflation. During the 2002-2006 period, therefore, 

other factors were retarding inflation by about 1 percent over the four years. 

During this period, wage inflation was stable as the rise in price inflation was not 

passed through into wages. This may have been due to the relatively high 

unemployment rate when the third shock occurred as compared particularly to 

the unemployment rate when the first shock occurred. 
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Summing up the evidence on the trajectories of inflation and output, the 

major points are that the 2000 episode was completely anomalous for output, 

while the major news on recent inflation is that there appears to have been no 

pass-through of higher energy prices into wages. 

Offsetting forces?

It seems clear that the disappearing energy crisis is not primarily due to 

lack of energy shocks. This would leave the second and third potential causes. 

The lack of a response might be due to smaller amplifiers in the macroeconomic 

transmission mechanism, or it might be due to offsetting forces of 

macroeconomic policy or exogenous events. Sorting out these two forces is 

clearly a major task, but I will provide a few suggestions on the question. 

We first examine the question of offsetting forces. Here, we simply look at 

the question of whether other major forces affecting aggregate demand were 

moving with or against the shock variables. For this purpose, I examine two 

variables. The first is the ratio of exogenous spending to potential GDP (“Exog”); 

for this calculation, I define exogenous spending as government current 

purchases and investment plus exports. A second variable is the nominal interest 

rate on the three-month Treasury bill rate (the real interest rate gives slightly 

different results). 

 I then examine the correlation structure of these two aggregate demand 

variables with the oil- and energy-shock variables. The results for the three major 

shock periods are shown in Table 3 (the periods are two quarters longer than the 

shock period to allow for lags). Exogenous spending was negatively correlated 

with the first price shocks, indicating that the contractionary drag of the energy 

shock was reinforced by the contractionary force of export and government 

purchases. By contrast, exogenous forces were positively correlated with the 

price shock in the second and third periods, indicating that they were offsetting 

the price shock. 
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 The effect of interest rates was also mixed. Interest rates were negatively 

correlated with the price shock in the first shock period, but positively correlated 

in the second and third period. This indicates that monetary policy (to the extent 

that policy determines real interest rates) reinforced the price shock in the second 

and third periods. In no period were both forces operating to buffer the price 

shock. 

 Declining impact of shocks?

 The big question remains whether the macroeconomy has become less 

sensitive to exogenous or policy shocks in recent years, with insensitivity to oil 

prices being the primary question raised in this paper. Investigating this issue 

requires taking a firm stance on the structure of the macroeconomy. In this 

section, I take a modest step by examining a small equation for aggregate 

demand and looking at the trend in variability and coefficients. 

 For this purpose, I take a very simple one-equation representation of the 

macroeconomy: 

(2) CU(t) = α0 + α1*Exog(t) + α2*CU(t-2) + α3TB3(t-2) + α4 Oilshock(t) + AR1 

where CU = ratio of output to potential output, Exog = ratio of exports plus 

government spending to potential output, TB3 is the nominal three-month 

Treasury bill rate, and Oilshock is the oil-shock variable. The αi are estimated 

coefficients. Estimating this equation over the period 1950:Q1 to 2007:Q2 gives 

coefficients with the appropriate sign and size. 

The question is whether the coefficients have changed over time. For this 

exercise, I estimate equation (2) for four subperiods, 1950:1-1970:1, 1960:1-1980:1, 

1970:1-1990:1, and 1987.2-2007:2. I then show the coefficients in Table 4. (A 

similar approach with a different structure was undertaken by Blanchard and 

Gali [2007].) 
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While the results will be sensitive to different specifications and sample 

periods, they suggest strongly that the impact of exogenous spending continues 

to be relatively strong, perhaps even increasing slightly over the period. On the 

other hand, the impact of the oil-shock variable declines sharply over time and is 

close to zero in the last two decades – a period that excludes the earlier price 

shocks and includes only the shocks after 1987. 

We can get another view of the contribution of different factors by 

examining rolling estimates of volatility over time. Figure 4 shows the subperiod standard deviations of changes in four policy or shock factors along with 

inflation and output. These volatility measures compute the standard deviation 

of the four-quarter changes for each of the five subperiods shown in the 

accompanying legend. 

Beginning with energy prices, this graph shows the increase and then 

decrease in the volatility of oil- and energy shocks over the postwar period. The 

increase in volatility from the 1950-70 period to later periods is extremely 

dramatic. There has been only a modest decline in volatility, particularly of the 

oil-shock, since its peak in the 1970-1990 period. In terms of macroeconomic 

impact, the decreasing macroeconomic sensitivity of output to oil-price shocks 

has accompanied declining shocks over the period since 1970. This 

unambiguously leads to a smaller impact of oil and energy-price shocks on the 

economy since the 1970s. 

What of exogenous spending shocks? The stunning point is that the 

variability of the exogenous component has declined by a factor of five since the 

first period. This sharp decline in variability of the exogenous factors is fighting 

against a constant or even perhaps increasing multiplier, with the likely outcome 

being a lower volatility of output. The endogeneity and changing structure of 

monetary policy requires a much more complicated economic and statistical 

structure than the model used here, but it is worth noting that the volatility of 

interest rates first increased and then decreased over the period. The 
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interpretation of this is ambiguous, however, because it would involve assessing 

whether the movements in the different periods were pro- or anti-cyclical. 

The last two sets of bars show the variability of output and inflation. Both 

of these show a decline in variability – as suggested by the theory of the Great 

Moderation. Over the range of observations, the variability of output has 

declined by almost two-thirds while that of inflation declined by more than half. 

The net assessment is that the declining impact of oil and energy-price 

shocks on the economy results from a combination of both declining sensitivity 

of the economy to energy-price shocks and from a decline in the variability of 

energy and oil prices since the 1970s. The declining sensitivity appears 

quantitatively more important, but the estimates of the sensitivity parameter are 

hardly well-determined. 

Conclusion

So what should we conclude? To begin with, the oil shock of 2002-2006 

was different from those of earlier period. If we measure the shock as the income 

effect per year of the price increases, the shock was substantially smaller than the 

shocks of the 1970s. It occurred more gradually, and the change was much less of 

a surprise in the context of past experience. Roughly speaking, the shock was 

about one-third as large as the shocks of the 1970s. 

In terms of effects, the impact of the shock on inflation was qualitatively 

similar although quantitatively different from the earlier shocks. The rise in PCE 

inflation in the recent shock was consistent with less than full pass-through of the 

energy-price increase. Unlike the shocks of the 1970s, there appears to have been 

no substantial pass-through of the energy-price increases into wages or other 

prices. 
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The impact of the shock on output was completely different from earlier 

episodes – indeed the sign was opposite. Output continued to grow relative to 

potential output after the shock, and unemployment continued to fall. The 

reason for the anomalous output impact is unclear. One possible reason is that 

the shock was too small to affect the overall pace of economic growth. 

Additionally, there is modest evidence that the transmission mechanism 

from energy prices to output has changed from negative to neutral over the last 

three decades. The reasons for the declining sensitivity are not completely 

understood, but two underlying causes seem plausible. First, there is evidence 

that the Federal Reserve reacted more sensibly to energy prices in the 2000s, 

looking more at core inflation than total inflation and paying more attention to 

the superlative PCE price index than the flawed CPI of the 1970s and early 1980s. 

Perhaps experienced hands at the Fed remembered history and decided not to 

repeat it. Perhaps they correctly judged (correctly in my view) that the energyprice shock was a one-time shock to the price level that would not be passed 

through into wage inflation. 

A second and more speculative reason for the muted macroeconomic 

reaction is that consumers, businesses, and workers may see oil-price increases as 

volatile and temporary movements rather than the earth-shaking changes of the 

1970s. Returning to the oil-price-as-tax-increase theory, consumers might view 

oil-price increases as temporary rather than permanent tax increases, and their 

reactions would therefore be correspondingly smaller. Similarly, businesses 

today might build energy-price volatility into their plans and investments, and 

large price changes would not upset operations as much as in earlier periods. A 

similar set of factors might lead workers and unions to absorb declines in real 

wages induced by energy prices rather than go on strike in an attempt to 

recapture losses that might turn out to be transitory. All of these factors would 

tend to reduce the impact of energy-price shocks on the macroeconomy. 
- 17 -

In the end, this suggests that much of what we should fear from oil-price 

shocks is the fearful overreactions of the monetary authority, consumers, 

businesses, and workers. A cautious reading today suggests that policymakers 

should not be afraid of a Big Bad Oil Shock. The most recent evidence suggests 

that the economy is robust in the face of major energy shocks. The economy 

weathered an increase in real oil prices of 125 percent from 2002 to 2006 without 

any major strain. This suggests that policymakers should focus on fundamentals 

such as employment, real output, and containment of inflation as well as the 

instabilities caused by financial innovations and risk-taking. Oil-price shocks are 

neither so big nor as bad as in the 1970s.
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Oil-priceshock dateOil-pricepeak date

Change in 

real oil 

price (%)

Change in 

unemployment rate (%

points)

Change in 

output gap 

(% points)

Change in 

PCE 

inflation 

(% points)

Change in

CPI 

inflation 

(% points)

Change in 

labor productivity growth 

(% points)

1973Q3 1975Q2 155 4.1 -7.5 2.5 2.5 -1.8

1978Q4 1980Q3 97 1.8 -6.3 2.7 3.6 -2.1

1990Q3 1990Q4 27 0.4 -1.5 0.5 0.7 -0.5

2002Q4 2006Q2 125 -1.2 2.1 1.4 1.7 -1.5

Table 1. Macroeconomic data for major oil shocks 

The change in the real oil price is the arithmetic percentage change from the shock date 

to the oil-price-peak date. The other columns show the difference between the series at 

the oil-price-peak date and the series at the oil-price-shock date. For example, the 

unemployment rate change of 4.1 percentage points for the first shock equals the 

unemployment rate of 8.9 percent in 1975:Q2 minus 4.8 percent in 1973:Q3. Productivity 

and inflation growth are four-quarter logarithmic changes in percent per year. 
- 19 -

Period

Oil shock* Energy 

shock**

 [Percent per year***]

1973:Q3-75:Q2 2.1% 0.7%

1978:Q4-1980:Q3 2.4% 1.4%

1990:Q3-90:Q4 3.0% 1.9%

2002Q4-2006:Q2 0.7% 0.6%

* Percent of national oil consumption

** Percent of personal consumption expenditures

*** Shock from beginning to end divided

 by number of years

Table 2. Scaled energy and oil shocks 

The table shows the total scaled oil and energy shocks for the four major oil-shock 

periods. This measure annualizes the variables by taking the total change from 

beginning to end divided by the number of years. 
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Period and shock

Aggregate demand variable

Exogenous 

spending

Nominal interest 

rate 

1973:2 to 1975:2

Energy -0.18 -0.15

Oil -0.18 -0.17

1978.2 to 1980.3

Energy 0.46 0.67

Oil 0.46 0.67

2002.2 to 2006.2

Energy 0.65 0.89

Oil 0.69 0.91

Table 3. Correlation coefficients of shocks with aggregate demand 

variables 

The table shows the correlation coefficients of the energy- and oil-shock variables with 

two major variables affecting aggregate demand. Positive changes in the shock 

variables and the real interest rate are contractionary, while a positive change in the 

exogenous-spending variable is expansionary. 
- 21 -

Estimated coefficient 1950-70 1960-70 1970-90 1987-2007

Exogenous spending

Coefficient 0.24 0.67 1.13 0.97

Standard error (0.19) (0.29) (0.34) (0.21)

Oil-price shock

Coefficient -4.48 -0.54 -0.19 -0.11

Standard error (3.92) (0.32) (0.26) (0.18)

Table 4. Coefficients on exogenous spending and oil-price shock in 

aggregate demand equation, various periods 

The table shows the estimated coefficients for equation (2) in the text for different 

subperiods. The exogenous spending coefficient is α1 while the oil-price shock variable 

is α4 .
- 22 -

-.01

.00

.01

.02

.03

.04

.05

.06

.07

.08

50 55 60 65 70 75 80 85 90 95 00 05

Cumulative shock oil and energy (fraction of GDP or PCE)

Oil

Energy

Figure 1. Cumulative energy and oil shocks 

Figure shows the cumulative total shocks for each concept. The oil-shock variable is 

scaled by GDP while the energy-shock variable is scaled by personal consumption 

expenditures. 
- 23 -

-.08

-.06

-.04

-.02

.00

.02

1974 1975 1978 1980 2002 2004 2005

Output shock

Energy shock (-)

Oil shock (-)

Oil, energy, and output shock

(relative to period of price shock)

Figure 2. Price shocks and output 

Figure shows the trajectory of GDP (as a fraction of potential GDP) and the energy and 

oil-shock variables for the three major price shock periods. Note that the shock variables 

are associated with declining output in the first two periods but not in the third period. 

Each variable is normalized to equal 0 in the shock period. 
- 24 -

.00

.01

.02

.03

.04

.05

73 74 75 78 79 80 02 03 04 05

PPCE shock

CPI shock

Energy shock

Oil shock

Oil and energy shock and inflation change

 

Figure 3. Price shocks and inflation 

Figure shows the trajectory of two inflation rates (CPI and PCE price index) and the 

energy and oil shocks. Each variable is normalized to equal 0 in the shock period. 
- 25 -

.000

.005

.010

.015

.020

.025

.030

Exog Energy Oil Int Rate Output Inflation

1950-70 1960-80 1970-90

1980-2000 1987-2007

4-quarter volatility

 

Figure 4. Variability of shocks, subperiods

Figure shows the standard deviation of the four-quarter change in each variable for 

different subperiods. The variables are “Exog” for the ratio of exports and government 

purchases to potential output, “Energy” and “Oil” for the scaled energy-price and oilprice shock variables shown in Figure 1, and “Int rate” for the Federal funds rate. 

“Output” is the ratio of output to potential output while “Inflation” is the PCE price 

index.
- 26 -

References

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Hamilton, James D. [1996]. “This Is What Happened to the Oil Price/Macroeconomy 

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Hamilton, James D. and Ana Maria Herrera [2004]. “Oil Shocks and Aggregate 

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<http://www.brook.edu/views/papers/perry/20011024.htm>. 

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