Luke M. Shimek

Yi Wen

English

Research Papers in Economics

December 2007 MonetaryTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
W
hile oil prices are near record highs, the U.S.
economy has yet to experience a sharp rise in
inflation as it did in the 1970s and early 1980s.
Why the difference? 
The relationship between oil prices and the U.S. economy
has gone through dramatic changes since the 1980s. Changes
in the GDP deflator and the price index of total imports (which
reflect domestic and traded-goods price movements, respectively)
were significantly correlated with changes in oil prices during
the 1973-83 oil crisis (see chart). In that period, the correlation
between oil price changes and GDP deflator inflation was 0.4;
the correlation between oil price changes and import price infla-
tion was even closer, 0.9. The closer relationship of oil price
changes to import price changes suggests that the share of for-
eign energy imports in total imports is larger than the share of oil
expenditures in GDP. However, since 1984, the close relationship
between oil price changes and the U.S. economy has weakened
significantly: Correlation with the GDP deflator has decreased to
0.13, while correlation with import price changes has decreased
to 0.65.
Associated with the decline in these correlations are signifi-
cant reductions in price volatility. The volatility of GDP deflator
inflation—measured as standard deviation from sample mean—
was 0.019 during the oil crisis period and 0.0079 in the post-
1984 period, a 60 percent reduction. Similarly, the
standard deviation of import price changes has
decreased from 0.136 to 0.037 in the post-1984
period, a 70 percent reduction. Meanwhile, the
reduction of oil price volatility has not been as
dramatic, decreasing from 0.548 to 0.297 (only
a 45 percent reduction). 
Economists do not have a complete answer
for what caused these changes, but they have
offered some conjectures. Gregory Mankiw1
claims an important clue is that the economy is
far more energy-efficient today than it was in the
past, in part because economic activity is based
more on services and less on manufacturing. For
example, the energy consumption per dollar of
GDP has decreased by about 50 percent today
compared with the early 1970s. As a result,
energy prices matter less today. According to
Olivier Blanchard and Jordi Gali,2 in addition to
the smaller share of oil in production, more-
flexible labor markets and improvements in
monetary policy have contributed to the increased price stability.
In particular, decreased wage rigidities in the labor market may
have helped reduce the impact of oil shocks on output, and the
stronger commitment by central banks to maintaining a low and
stable rate of inflation may have ameliorated the effect of oil
price increases on inflation.
According to Federal Reserve Bank of St. Louis President
William Poole, “Market adjustments have been the hero in pre-
venting energy price increases over the past four years from dis-
rupting economic growth.” While higher gas prices have put a
strain on consumers, “there is no energy crisis and households
and firms are adjusting in a sensible way to price increases.”3
In sum, better adjustments and responses to oil price shocks
by both the government and the private sector have been the
essential contributors to price stability.
—Yi Wen and Luke M. Shimek
1 Mankiw, Gregory. “Where Have All the Oil Shocks Gone?” 
http://gregmankiw.blogspot.com/2007/10/where-have-all-oil-shocks-gone.html
(accessed 10/31/2007).
2 Blanchard, Olivier and Gali, Jordi. “The Macroeconomic Effects of Oil Shocks:
Why Are the 2000s So Different from the 1970s?” NBER Working Paper 13368,
National Bureau of Economic Research, 2007.
3 See two speeches by William Poole: “Energy and the U.S. Macro Economy”
(http://stlouisfed.org/news/speeches/2007/07_24_07.html) and “Energy Prices and
the U.S. Business Cycle” (http://stlouisfed.org/news/speeches/2007/03_02_07.html).
Oil Shocks and Price Stability
research.stlouisfed.org
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Percent Change Year-to-Year
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Total Import Prices (left axis)
GDP Deflator (left axis)
Spot: West Texas Crude (right axis)
Percent
SOURCE: Haver Analytics/BEA/Wall Street Journal.

Oil shocks and price stability

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Oil shocks and price stability

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