EMF SR 9: The Economic Consequences of Higher Crude Oil Prices

Although the average world crude oilprices have risen more than $30 per barrel since the end of 2001, theU.S. economy has remained strong, growing at about 3.5% annually overthis period. This experience may suggest that the U.S. economy hasentered a new era where it is invulnerable to higher oil price levelsand oil price shocks. This report summarizes and evaluates the previousresearch and studies on the economy’s response to past oil priceincreases in order to understand whether oil price shocks are no longera macroeconomic problem.

A key conclusion is that sudden oil price shocks affect the economy fardifferently than do higher oil price levels achieved over a number ofquarters. When oil prices move gradually higher (perhaps somewhaterratically), as they have done over the last several years, they donot directly result in economic recessions, even though the economy maygrow modestly slower. Moreover, economic policies may cushion theimpact 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 highercosts and prices throughout the economy. These adverse impacts arelikely to exceed oil’s direct share (in value terms) in the economy,because macroeconomic frictions augment the initial effects. If theseshocks happen at a time when baseline economic conditions prior to theshock display relatively weak economic growth and high inflation rates,they may have considerably larger effects than when the economy isgrowing relatively rapidly with little or no inflation. When monetaryand demand-oriented fiscal policies are restricted by inflationaryfears, the economic damages could be significant.

The report attempts to provide some guidance on the relative size ofthese impacts. When oil prices move upward gradually, the economicimpacts are relatively modest. Estimates from large-scale macroeconomicmodels seem to measure the impacts under these conditions. When oilprice shocks scare households and firms and cause temporary idleresources in the near term, the impacts are likely to be substantiallylarger than estimated by these models and may be closer to thoseevaluated by less structured, time-series (vector autoregressive)models based upon historical data.