How Oil Price Shocks Influence America’s Economy -- Feature -- July 28, 2010

Jul 28, 2010

Oil Price Shocks and U.S. Economic Activity
RFF Feature
July 28, 2010

New RFF analysis finds global influences, such as oil price shocks, may be secondary to domestic influences when it comes to understanding the causes of U.S. economic fluctuation.

Economists have examined the relationship between oil price shocks and U.S. economic activity since the 1970s and early 1980s—when oil prices rose sharply and the United States plunged into recession. The early research quantified the relationship between oil prices and U.S. economic activity and examined the avenues through which oil price shocks might affect U.S. economic activity.

More than two decades later, however, the relationship between oil prices and the U.S. economy seemed to have changed dramatically. Throughout much of the 2000s both oil prices and U.S. economic activity rose strongly until the recession hit in early 2008. Some researchers have attributed the differences to such factors as increased global financial integration, greater flexibility of the U.S. economy (including labor and financial markets), the reduced energy intensity of the U.S. economy, increased experience with energy price shocks, better monetary policy, and good luck—that is, smaller and less frequent shocks. Other researchers assert that the relationship between oil price shocks and U.S. economic activity is much smaller than previously thought, and that other factors must have shaped U.S. economic activity.

In Oil Price Shocks and U.S. Economic Activity: An International Perspective, Nathan S. Balke, Stephen P.A. Brown, and Mine K. Yücel analyze these differing views. They develop a world economic model that captures the influence of oil supply shocks and other economic shocks. Their estimation of the model identifies the various sources of world oil price movements and economic fluctuation and the consequent effects on U.S. economic activity.

Their findings? World oil price shocks in the 1970s and early 1980s reflected different combinations of shifts in oil supply and demand than the early 2000s, which accordingly meant differing effects on oil markets and U.S. economic activity. In addition, they confirm that domestic shocks—such as those to productivity and investment—dominate the movements in U.S. economic activity.

U.S. GDP fell sharply after the oil price increases in the 1970s and early 1980s, primarily because domestic productivity shocks reduced output. Oil supply shocks only mildly reinforced that economic weakness. In the 2000s, however, U.S. GDP continued to rise as oil prices rose because changes in U.S. investment efficiency, total factor productivity, and preferences completely overwhelmed the extremely mild drag contributed by oil supply shocks.