EMF Publications

EMF SR 9 The Economic Consequences of Higher Crude Oil Prices

Special Report

Hillard G. Huntington - Stanford University

Published by
Stanford University, 2005

Although the average world crude oil prices have risen more than $30 per barrel since the end of 2001, the U.S. economy has remained strong, growing at about 3.5% annually over this period. This experience may suggest that the U.S. economy has entered a new era where it is invulnerable to higher oil price levels and oil price shocks. This report summarizes and evaluates the previous research and studies on the economy’s response to past oil price increases in order to understand whether oil price shocks are no longer a macroeconomic problem.

A key conclusion is that sudden oil price shocks affect the economy far differently than do higher oil price levels achieved over a number of quarters. When oil prices move gradually higher (perhaps somewhat erratically), as they have done over the last several years, they do not directly result in economic recessions, even though the economy may grow modestly slower. Moreover, economic policies may cushion the impact and offset much of the adverse effects.

When oil interruptions or other surprise events jolt oil prices, however, the economy will be more vulnerable to recessions and higher costs and prices throughout the economy. These adverse impacts are likely to exceed oil’s direct share (in value terms) in the economy, because macroeconomic frictions augment the initial effects. If these shocks happen at a time when baseline economic conditions prior to the shock display relatively weak economic growth and high inflation rates, they may have considerably larger effects than when the economy is growing relatively rapidly with little or no inflation. When monetary and demand-oriented fiscal policies are restricted by inflationary fears, the economic damages could be significant.

The report attempts to provide some guidance on the relative size of these impacts. When oil prices move upward gradually, the economic impacts are relatively modest. Estimates from large-scale macroeconomic models seem to measure the impacts under these conditions. When oil price shocks scare households and firms and cause temporary idle resources in the near term, the impacts are likely to be substantially larger than estimated by these models and may be closer to those evaluated by less structured, time-series (vector autoregressive) models based upon historical data.