does all this, as many economists are doing these days, one sees effects of about one - third of 1 percent on unemployment and slightly more for core inflation rates for a permanent shock in the price of oil of $ 10 a barrel. 3 with appropriate transformations, these structural effects appear to be a good bit smaller than the implications of the reduced - form correlations. why the difference? many sources of discrepancy between the reduced form effects and the structural effects are possible. one involves consumers - perhaps a serious oil price shock could affect consumersa€™ confidence or spending plans in a way that would not be captured by working out the effect of normal income and price elasticities. capital investment may also be affected if the oil price shock encourages producers to substitute less - energy - intensive capital for more - energy - intensive capital. of course, such a substitution will not necessarily lower aggregate demand if it requires more investment demand for new energy - saving equipment. oil is a pervasive commodity, and other types of non - model effects are possible, but these consumption and investment effects seem the most obvious. how should monetary policy respond to oil price shocks? monetary policy makers in this country have a dual mandate, to stabilize prices and to maximize sustainable employment in the long run. their response to oil price increases should focus on these two objectives. at one extreme, monetary policy makers might focus exclusively on the demand - reducing effect of oil shocks and try to stabilize unemployment rates. the risk from this approach is that prices would rise the full amount implied by the shock and would more likely be passed through into further wage and price increases. continuing inflation rates could bump up the full amount of the initial boost in inflation. the continuing inflationary potential from the oil price shock would, in effect, be maximized. at the other extreme, monetary policy makers could focus exclusively on neutralizing the initial impact of the shock on inflation. given the initial oil price shock, this approach would entail reducing demand enough to stabilize overall, or core, inflation rates. if prices were at all sluggish in their response to changes in unemployment, this approach could entail large increases in unemployment from the shock. most observers would choose a policymaking approach somewhere between these two extremes. if, for example, monetary policy makers tried to keep overall nominal income on a steady path, the direct rise in nominal income from the oil price shock would be met by a fall in real income from somewhat higher unemployment. the result would be a

economic event of the 1970s, oil price shocks forced monetary policy makers to rethink all their rules and added new chapters to macroeconomic textbooks. today the question of how to respond to oil price spikes is better understood, but the outcomes are no more pleasant. it is virtually inevitable that shocks will result in some combination of higher inflation and higher unemployment for a time. but i must stress that the worst possible outcome is not these temporary increases in inflation and unemployment. the worst possible outcome is for monetary policy makers to let inflation come loose from its moorings.