- 1 - 

### 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 Mar ch 2003, many economists feared that the war would lead to a sharp decline in Ir aqi oil production, a spike in oil prices, and a woeful economy that would follow th e scripts of the oil shocks of 1973, 1978, and 1990. There was in fact a modera te decline in world oil production, and real oil prices increased from $20 in 2 001:4 to $62 in 2006:3. But the ailments associated with earlier oil-price incr eases did not appear. Instead, output continued to grow rapidly, inflatio n was moderate, unemployment fell, consumers remained happy, and productivity grew at close to its postwar norm. 1

Macroeconomists would be out of bu siness 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 robust ness 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 show n 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 note s, “Notes on Data and Methods for ‘Who’s Afraid of the Big Bad Oil Shock?’,” Au gust 27, 2007, available on the web at http://www.econ.yale.edu/~nordh aus/homepage/Data_BPEA_20072_v2.pdf

. (Version is Big_Bad_Oil_Shock_Meeting.doc.)- 2 - 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 th e impact of the most recent shock. The most comprehensive study is a prelimin ary paper by Blancha rd and Gali [2007].
Most research focuses on the role of mo netary 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 th e major data on the behavior of the economy following the four oil-price shoc ks after the 1973 Arab-Israeli war, the 1978 Iranian revolution, the 1990 Iraqi in vasion 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 peri od 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 co ntrols, 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-pr ice increase of 125 percent, which about as large as the average of the 1970s o il-price increases. The 1990 increase was smaller and short-lived, while the most recent increase wa s 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.- 3 - The next two columns show the macroeconomic response in terms of the unemployment rate and the percentage ou tput 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 fe ll by slightly more than 1 percentage point, while the output gap increased slig htly. The most recent episode contrasts sharply with the shocks of the 1970s, wh en 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 sh ortly, 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 de cline 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 dec line 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 ma jor difference is that the oil shock was followed by a continued economic ex pansion 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.- 4 - 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 chan ge, there will actually be no response of multifactor productivity to price changes, for the resp onse is only substitution along a given technological frontier. However, if we examine partial productivity measures, such as labor productivity, then there migh t be a response, such as when labor is substituted for energy.

It is easy to forget how small the su bstitution 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 capita l equipment at the same rate as before the price shock, all inputs and output s would be identical, and there would consequently be no productivity impact.

In a simplified one-product neoclassica l world, the productivity response to an oil-price change is approximately pr oportional 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). (Y ou can substitute energy for oil in this equation to get the energy-price impact.) An illustrative calculation will indicate how small the substitution-productivity e ffect would be. We estimate that the one-year price-elasticity of demand fo r 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 GD P for this period of 3 percent, the productivity effect of a do ubling 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- 5 - fundamental economic reason why energy-p rice shocks should lead to recession and unemployment.

A more likely mechanism is that pr ice shocks work through aggregate demand. There are actually two important ways that price shocks can affect aggregate demand. A first is through mo netary policy: Higher energy prices produce inflation, which may lead the Federal Reserve to tighten money and slow the economy. (This is the mechanism th at 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 tr igger a monetary tightening and thereby lead to a contractionary impa ct of higher energy prices.

The contractionary effect of moneta ry 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 char acter who spoke prose without knowing it, reacted powerfully to energy-price driv en 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 Fe d follows the core Taylor rule, then this second contractionary mechanism woul d not operate until and unless energy prices get transmitted into a further ro und 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 pa ss-through will exceed the direct impacts
that are removed in calculat ing the core inflation rates. A rough estimate is that the total impact on consumer prices is about 1.8 times the direct effect.)- 6 - There is some evidence that the Fed behaves as it speaks. If we estimate a rolling regression Taylor Rule with sepa rate terms for core PCE inflation and energy PCE inflation, we see that th e coefficient on energy inflation was essentially zero in the 1990-2007 peri od. 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 on e-time shocks to energy prices.

The second mechanism, and one that was emphasized in the 1970s by members of the Brookings Panel, is “oil pric e 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 consum ption. 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 en ergy spending, and therefore have high
MPCs.

The seller side is more complex. An in crease 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 taxe d) had a high marginal tax rate. A substantial fraction of the post-tax corp orate 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 spendi ng would only marginally be on U.S. production. Going through this chain of sp ending, it would be plausible to argue that the marginal expenditure on U.S. pr oduction 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.- 7 - Measuring Oil Shocks

The second challenge in studying o il-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 no minal 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 pr ices for their economic importance.

It is useful to go back to first prin ciples 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 va riable 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-in crease 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 de fining our shock variable. This would be measured by the value of purchases time s the change in the price. That is, the income effect = (PX) Δ P, 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 co nsiders only oil. We therefore define a second variable which is an “energy-sh ock variable.” This is conceptually the
same as the oil-shock variable but uses the price and quantity of personal consumption expenditures on energy products (primar ily gasoline, electricity, and heating fuels). For this second shoc k variable, we use personal consumption expenditures as the denominator. The adva ntage of the energy-s hock variable is- 8 - that it is more inclusive and cons iders the impact on consumers. The disadvantage is that it omit s second-round effects, such as the effect of oil prices on jet fuel and thence on air fares.

Figure 1 shows cumulative measur es of the energy- and oil-shock
variables. We show the cumulative tota ls because the shock variable will differ depending upon the length of the differe ncing period. Table 2 shows the changes
in the scaled shock variables over the sh ock 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 shoc k, 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 20 02-2006 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 th e energy-shock variables.

The historical context and shape of th e 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 st ability of oil prices before the fall of 1973, the changes that ensued were larg e-sigma events, similar in psychological effect to the collapse of the World Tr ade Towers or Hurricane Katrina. For example, the largest four-quarter change in the real oil pr ice between 1950 and 1973 was 10 percent. In the next two ye ars, the change was as high as 160 percent. My recollection is that no seri ous forecaster in 1 972 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- 9 - 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 pe r 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 wa s not unthinkably large to market participants.

Mechanisms for declining impact of oil shocks

It is worth pausing to consider why o il shocks might have a smaller impact on the economy today than in earlier pe riods. We can preliminarily consider three reasons: smaller shocks, smaller multipliers, and other forces. (Many of these issues were originally inve stigated 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 ou tput. In the simplest macroeconomic framework, the oil-price multip lier on output is smaller.- 10 - A third reason for a smaller impact is that other variables might have reinforced the contractionary and inflatio nary 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 comm odity shortages, poor grain harvests, political business cycles, collapse of the Bretton Woods system, disappearing anchovies, and an army of plagues that re inforced 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 re inforced 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 patter n 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 shoc ks. For these comparisons, I plot the cumulative oil and energy-shock vari ables 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 th e 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 20 00s. Whereas output paralleled the (negative) shocks of the 1970s, the relati onship reversed in the 2000s. The sample- 11 - 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 th e energy shocks and inflation. For this graph, we use both the CPI (whi ch policymakers tended to follow in the 1970s) and the PCE price index. The rela tionship 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 be tween the energy-price shock and PCE inflation. By construction, if the only factor changing during the period was energy-price inflation, the two lines woul d coincide (almost) exactly. This is because the PCE price index is a superlat ive index that uses virtually the same construction as our energy-price shock va riable. (There is ac tually a small thirdorder difference because the PCE is a Fish er index while our construction is a Törnqvist index, but the diffe rence 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 sh ock 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 accounte d 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 flaw ed construction fr om 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 stab le as the rise in price inflation was not passed through into wages. This may ha ve 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.- 12 - Summing up the evidence on the trajec tories of inflation and output, the major points are that the 2000 episod e 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 en ergy 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 migh t be due to offsetting forces of macroeconomic policy or exogenous even ts. Sorting out these two forces is clearly a major task, but I will provid e 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 fo rces affecting aggr egate demand were moving with or against the shock variab les. For this purpose, I examine two variables. The first is the ratio of exog enous spending to potential GDP (“Exog”); for this calculation, I define exogen ous 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 stru cture 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 pe riods are two quarters longer than the shock period to allow for lags). Exogen ous spending was negatively correlated with the first price shocks, indicating that the contractionary drag of the energy shock was reinforced by the contractio nary 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.- 13 - The effect of interest rates was also mixed. Interest rate s were negatively correlated with the price shock in the firs t shock period, but positively correlated in the second and third period. This indi cates 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 bo th 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 ex amining a small equation for aggregate demand and looking at the trend in variability and coefficients.

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

macroeconomy:
(2) CU(t) = α 0 + α 1 *Exog(t) + α 2 *CU(t-2) + α 3 TB3(t-2) + α 4 Oilshock(t) + AR1

where CU = ratio of output to potentia l output, Exog = ratio of exports plus government spending to potential ou tput, TB3 is the nominal three-month Treasury bill rate, and Oilshock is the oil-shock variable. The α i are estimated coefficients. Estimating this equation ov er 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, 1950:1-19 70:1, 1960:1-1980:1, 1970:1-1990:1, and 1987.2-2007:2. I then sh ow the coefficients in Table 4. (A similar approach with a different structure was undertaken by Blanchard and Gali [2007].)- 14 - 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 incr easing slightly over the period. On the other hand, the impact of the oil-shock vari able 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 cont ribution of different factors by examining rolling estimates of volatilit y over time. Figure 4 shows the subperiod standard deviations of changes in four policy or shock factors along with inflation and output. These volatility me asures 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 en ergy 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 volat ility, particularly of the oil-shock, since its peak in the 1970- 1990 period. In terms of macroeconomic impact, the decreasing macr oeconomic sensitivity of ou tput to oil-price shocks has accompanied declining shocks ov er 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 variab ility of the exogenous factors is fighting against a constant or even perhaps increa sing multiplier, with the likely outcome being a lower volatility of output. The endogeneity and chang ing 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- 15 - interpretation of this is ambiguous, ho wever, 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 va riability 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 observat ions, 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 declin ing impact of oil and energy-price shocks on the economy results from a co mbination 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 importan t, but the estimates of the sensitivity parameter are hardly well-determined.

Conclusion

So what should we conclude? To be gin 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, th e shock was substantially smaller than the shocks of the 1970s. It occurred more gr adually, and the change was much less of a surprise in the context of past expe rience. Roughly speaking, the shock was about one-third as large as the shocks of the 1970s.

In terms of effects, the impact of th e shock on inflation was qualitatively similar although quantitatively different from the earlier shocks. The rise in PCE
inflation in the recent shock was consiste nt 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.- 16 - The impact of the shock on output wa s 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 eviden ce that the transmission mechanism from energy prices to output has changed from negative to neutral over the last
three decades. The reasons for the dec lining sensitivity are not completely understood, but two underlying causes seem plausible. First, there is evidence
that the Federal Reserve reacted more sens ibly to energy prices in the 2000s, looking more at core inflation than tota l inflation and paying more attention to the superlative PCE price in dex than the flawed CPI of the 1970s and early 1980s. Perhaps experienced hands at the Fed re membered 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 th e price level that would not be passed through into wage inflation.

A second and more speculative re ason for the muted macroeconomic reaction is that consumers, businesses, and workers may see o il-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 correspondi ngly smaller. Similarly, businesses today might build energy-price volatility into their plans and investments, and large price changes would not upset operatio ns 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 re ading today suggests that policymakers should not be afraid of a Big Bad Oil Sh ock. 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 po licymakers should focu s on fundamentals such as employment, real output, and containment of inflation as well as the instabilities caused by financ ial innovations and risk-tak ing. Oil-price shocks are neither so big nor as bad as in the 1970s.- 18 -Oil-priceshock date Oil-pricepeak date Change in real oil price (%) Change inunemployment rate (% points) Change in output gap (% points) Change in PCE inflation (% points) Change in CPI inflation (% points) Change in labor product

ivity 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 da ta for major oil shocks

The change in the real oil pr ice is the arithmetic percentage change from the shock date to the oil-price-peak date. The other column s 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:Q 2 minus 4.8 percent in 1973:Q3. Productivity and inflation growth are four-quarter lo garithmic 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 consum p tio n ** Percent of p ersonal consum p tion ex p enditures *** Shock from be g innin g to end divided b y number of y ears



### Table 2. Scaled energy and oil shocks

The table shows the total scaled oil and en ergy shocks for the four major oil-shock periods. This measure annualizes the vari ables by taking the total change from beginning to end divided by the number of years.- 20 - 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 cont ractionary, 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 fo r equation (2) in the text for different subperiods. The exogenous spending coefficient is α 1 while the oil-price shock variable

is α 4 .- 22 - -.01

.00 .01 .02 .03 .04 .05 .06 .07 .08

50 55 60 65 70 75 80 85 90 95 00 05Cumulative 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 sh ock 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 shockOil and energy shock and inflation change



### Figure 3. Price shocks and inflation

Figure shows the trajectory of two inflatio n rates (CPI and PCE price index) and the energy and oil shocks. Each variable is no rmalized 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 1987-20074-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” an d “Oil” for the scaled energy-price and oilprice shock variables shown in Figure 1, an d “Int rate” for the Federal funds rate. “Output” is the ratio of output to potentia l output while “Inflation” is the PCE price
index.- 26 - 

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