EMF OP 18: Oil Prices and Inflation

Abstract:

The oil shocks of the seventies caused severe adjustment problems for oil-importing nations. Rapidly increasing oil prices created widespread joblessness and sharply higher consumer prices in these economies. These conditions confronted policymakers with a particularly pernicious tradeoff. Pressure on consumer prices could be eased by adopting restrictive policies that slowed down aggregate economic activity and worsened employment. Alternatively, policymakers could try to protect jobs but at the expense of possible increased inflation.

During the past several years oil prices have been falling, while inflation has weakened considerably. This more recent experience has reinforced the general public’s perception that oil prices and inflation are very much interrelated. Monthly reports on inflation are usually accompanied by the latest estimates of the change in energy prices.

This paper reviews several key aspects of the relationship between oil price and inflation. There has developed over the years an extensive literature on inflation that has been adequately reviewed elsewhere. Moreover, several other sources lucidly describe the interactions between oil prices and the general inflation process. Rather than duplicate these efforts, this paper will emphasize the available estimates of the effect of oil price increases on inflation in the United States.

These estimates are derived from detailed macroeconomic models of the United States Economy. These models were initially developed for explaining fluctuations in economic activity over the business cycle. Based on responses to economic conditions observed during the period following World War II, they focus on the determination of prices, expenditures, and income in the national economy. Since the 1970s, they have been extensively revised and expanded to incorporate important energy variables in order to study the consequences of oil shocks.

We develop in the next section several key conceptual points about the general inflation process. This discussion provides the appropriate background for the following section’s consideration of available estimates of the effect of oil prices on consumer prices during the 1970s. Next, we focus on some more recent estimates of this relationship available from an Energy Modeling Forum (EMF) study on the macroeconomic impacts of energy price changes. This study focused on the effects of output, inflation, and unemployment during the first four years after a hypothetical oil price change in the 1980s. It compared the responses of 14 prominent models of the aggregate economy (13 U.S. models and one Canadian model) to energy prices changes and to policies for cushioning the loss in real gross national product (i.e. adjusted for inflation) that results from sharp price increases.

The EMF results are discussed in two parts. We emphasize initially the broad conclusions about oil shocks and consumer prices that emanate from the comparison of models. In a second section we relate differences in these estimates among models to differences in observed characteristics of the participating models. A final section summarizes the key findings from this review of available estimates of the relationship between oil prices and inflation.

Reprinted in 1985 from Annual Review Energy, Vol 10, 1985, pp 317-339