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Oil Price Shocks and the Economy Mine K. Yücel Federal Reserve Bank of Dallas Forum on U.S. Energy Security Traditional and Emerging Challenges January 28, 2002 Resources for the Future, Washington DC Oil Price Shocks and the Economy • Do oil price shocks affect economic activity? • Do increases and decreases in oil prices affect the economy symmetrically? • Is the effect real, or is it the Fed? price spikes trigger U.S. recessions Oil Oil price spikes tendtend to betofollowed by U.S. recessions Index, Jan ' 82= 100 115 105 95 85 75 65 55 45 35 25 Source: NBER 15 49 52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 Do oil price shocks affect economic activity? • Eight out of ten post WW2 recessions followed by oil price shocks • Statistical evidence links oil prices to inflation, higher interest rates and higher unemployment rates • Consensus: An inverse statistical relationship between oil price changes and economic activity How does an oil price change affect the economy? • Supply-side economic impacts • Reductions in U.S. purchasing power • Interaction with monetary policy An unfavorable supply-side shock from higher oil prices Input Scarcity (Higher Oil Prices) GDP Growth Slows & Productivity Growth Slows Price Level Rises Interest Rate Rises Wage Growth Slows Unemployment Rate Rises Purchasing power effects • Oil price increase shifts purchasing power from oil-importing nations to oil-exporting nations • On net, demand for oil importer’s goods reduced • Lower consumption, lower GDP growth, higher saving and lower interest rates How sensitive is GDP to oil price shocks? • Empirical studies: The economy’s sensitivity to oil price shocks has declined in past decade • Monetary policy can shape how oil price shock is experienced: slower growth versus higher inflation Oil price shocks can magnify errors in monetary policy • Oil price shock => lower GDP growth, higher inflation • Counter-inflationary policy can aggravate GDP losses • Expansionary policy can aggravate inflationary pressures Is monetary policy the culprit? • Early statistical evidence: no relationship between industry activity and energy intensity--tight monetary policy was the culprit • Later evidence: oil price shocks have significant effects on economic activity apart from monetary shocks Is the oil price - economy relationship symmetric? • Rising oil prices seem to retard economic activity more than falling oil prices stimulate it. • Possible explanation: more economic adjustment costs and coordination problems with rising oil prices Adjustment costs • The economy experiences some costly adjustment to both rising and falling oil prices – When oil prices rise, slowing economic activity is further retarded by adjustment costs – When oil prices fall, stimulated economic activity is somewhat offset by adjustment costs • We then have asymmetry: rising oil prices retard economic activity by more than falling prices stimulate it The oil price - economy relationship has grown weaker in the past decade • Less impact on the underlying (“core”) inflation rate • Less negative effect on unemployment; employment one-half as sensitive to oil price shocks than in the 70s Policy Implications Monetary policy: Neutrality-- balance slower growth versus higher inflation Energy Policy: Lowering short-term oil price spikes--role of Strategic Petroleum Reserve?