Oil Shocks
Why Responses Differed

It is possible to distinguish three responses to the 1973-74 oil price shocks. Western Europe saw a large increase in unemployment. Attempts to apply Keynesian aggregate demand policies resulted in increases in nominal rather than real GDP via high inflation. Giersch and Sachs have stressed the important role of real wage rigidity in this process. Investment in Western Europe remained low throughout the seventies. All oil importers saw their Current Account (CA) deteriorate, although this deterioration was short-lived. In the United States, the CA also deteriorated throughout most of the seventies, with the exception of the bottom of the recession in 1975. Investment slowed, but less than in Western Europe. Unemployment reached a post-war peak in 1975, but responded quickly to the very Keynesian remedy of a tax cut in the second quarter of 1975.

Most LDCs experienced a clear deterioration of their CA, which persisted throughout the mid-seventies, in contrast to Western Europe and the US. The initial increase in unemployment was quickly reversed through expansionary fiscal policies and monetary policies which accommodated this expansion. In many cases private investment in the LDCs actually accelerated at the same time as government expenditure increased. This formed a striking contrast to events in the OECD, and in fact to much of currently accepted theory on the relation between government expenditure and private investment.

In Discussion Paper No. 65 Sweder van Wijnbergen attempts to explain responses to the 1973/74 oil shock. He uses a two-period model which allows a more satisfactory analysis of savings and investment and of the current account. The model also explicitly incorporates disequilibrium in labour and goods markets and so can give rise to either classical and Keynesian unemployment. Discussions of economic policy often focus on the potential conflict between short-run stabilization policies and longer-run adjustment needed because of changes in relative factor prices. In order to highlight this conflict, van Wijnbergen assumes that all markets are in a 'Walrasian' equilibrium in the second period (the 'Long Run').

There are two aspects to an increase in the price of an imported intermediate good like oil. First, it implies an increase in the price of an input into the production process, and so represents an aggregate supply shock. Second, for a given level of oil imports, more needs to be paid to the exporter. A larger share of domestic income needs to be transferred to that exporter, leaving less for domestic demand. This is called the transfer element and represents a shock to aggregate demand.

This analysis suggests the following interpretation of responses to the 1973/4 shock. The size of the supply shock depends on the share of energy in the value of total output. This ratio is approximately 40% higher in the industrial countries than in LDCs. The transfer element, however, is dependent on the ratio of energy imports to GNP. This ratio is 24% higher in middle- income oil-importing LDCs than it is in developed countries. The results suggest that the unemployment induced by the oil price shock was Keynesian in LDCs but neoclassical in Western Europe. This suggests why aggregate demand policies were generally contractionary in Europe and expansionary in most LDCs. The United States in 1973-74 is clearly a different case, because of controls on oil prices which remained in place until the late 1970s. These price controls eliminated the supply shock, and this suggests that US unemployment in 1974 and 1975 was Keynesian in nature. It also explains the quick response of the economy to the Keynesian stimulus of a tax cut in 1975.

The author also shows that lower foreign real interest rates (such as those characterizing post-1973 international capital markets) will lead to higher investment under Keynesian unemployment, but not to higher actual investment under classical unemployment. No such increase in investment will occur when there is classical unemployment, because real wage pressure has eroded profitability too much. This analysis, in conjunction with the hypothesis that Western Europe experienced classical unemployment and LDCs Keynesian unemployment as a result of the 1973-74 oil price shock, might therefore explain why investment behaved differently in Western Europe as compared to the LDCs.


Oil Price Shocks, Unemployment, Investment and the Current Account: An Intertemporal Disequilibrium Analysis
S van Wijnbergen

Discussion Paper No. 65, June 1985 (IM)