VoxEU Column Energy Macroeconomic policy

The oil price and the macroeconomy: What’s going on?

In the 1970s, large increases in the price of oil were associated with sharp decreases in output and large increases in inflation. In the 2000s, even larger increases in the price of oil were associated with much milder movements. This column attributes the difference in the US to more flexible labour markets and more credible monetary policy during the Great Moderation.

Whereas in the 1970s large increases in the price of oil were associated with sharp decreases in output and large increases in inflation, in the 2000s, and at least until the end of 2007, even larger increases in the price of oil were associated with much milder movements in output and inflation. What has happened to the oil-macroeconomy relationship?

One answer is that there are different shocks behind the two sets of price increases. In the 1970s oil price hikes were triggered by changes in supply conditions (as was the case with the 1973 oil embargo in response to the Arab-Israeli war and the 1979 oil price surge following the Iranian Revolution), recent high oil prices stemmed from increased demand from emerging countries that also drives up expenditure on US goods, thus attenuating the negative effects of higher energy prices on US production (Kilian 2007, 2009, Lippi 2008, Lippi and Nobili 2008).

Another answer, offered by Blanchard and Gali (2007) is that the vanishing correlation between oil prices and the business cycle is the result of important structural changes modifying the transmission mechanism of oil shocks of similar sources and magnitude. They point out that the effects of a given change in the price of oil, identified as exogenous with respect to the US business cycle, have decreased substantially over time and conclude that the post-1984 effects of the price of oil on either output or the price level were roughly one-third of those for the pre-1984 period.

Identifying structural changes mediating oil price shocks

Our recent work (Blanchard and Riggi 2009) builds on the Blanchard-Gali analysis in order to identify changes in the structure of the economy that may explain the mild effects of the recent increases in the oil price on inflation and economic activity.

To this aim, we develop a theoretical model for the US economy and estimate the structural parameters that drive its dynamics for two samples, 1970–1983 and 1984–2007. Our empirical strategy consists in making the model-based responses of the economy to an oil price increase as close as possible to the empirical responses identified by Blanchard and Gali. Our estimates highlight two changes in the structure of the economy of major importance: vanishing real wage rigidity and improved credibility of monetary policy. Why are these structural changes able to account for the negligible pass through from oil to business cycle since the early 80s?

The strong decline in real wage rigidities point to strong “second-round” effects before 1984, and weak or nonexistent ones afterwards 1984. Faced with similar initial increases in the CPI (the "first round" effects), and for given employment, workers in the 1970s asked for and obtained a rise in nominal wages, which then led to higher prices and confronted the central bank with a worse trade-off between activity and inflation. In the 2000s, the same original increases in the CPI have not led to increases in nominal wages, and thus to further increases in prices.

As for monetary policy credibility, we characterise it as the extent to which the central bank is able to anchor inflation expectations on the part of the private sector. When credibility is low, the central bank may be unable to establish an anchor for inflation expectations, allowing actual inflation a greater influence on them. The smaller dependence of inflation expectations on short-run inflation dynamics that we find in the second period means better-anchored expectations and thus a more favourable trade-off between inflation and output.

Hence, the improvement in the estimated degree of monetary policy credibility delivers the following scenario. In the pre-1984 sample, after the oil shock, the adjustment of inflation expectations builds up over time. Conversely, in the post-1984 sample inflation expectations rise at the start but people anticipate that inflation will decrease later on. The central bank’s inability to directly anchor expectations leads to a larger increase in inflation, forcing a stronger monetary response in the pre-1984 sample than in the post-1984 one, thus leading to a larger decrease in output.


The two structural changes that we identify are consistent with the wider phenomenon known as the “Great Moderation” – the decline in macroeconomic volatility experienced by the US economy between the mid-1980s and the end of 2007.

  • On the one hand, weakening unions, increasing competition and declining minimum wage have made the structure of labor compensation much more flexible in the 2000s than it was in the 1970s. A recent contribution by Gali and Van Rens (2009) shows that the observed decline in US output volatility has been accompanied by a relevant rise in the volatility of the real wage.
  • On the other hand, our results are consistent with direct evidence of increased anchoring of inflation expectations, and in particular with the decrease in the response of expected inflation to an oil price surge since the mid-1980s documented by Blanchard and Gali.

Blanchard, Olivier J. and Jordi Gali (2007), “The Macroeconomic Effects of Oil Shocks: Why are the 2000s So Different from the 1970s?”, NBER Working Paper 13368

Blanchard, Olivier J. and Marianna Riggi (2009), “Why are the 2000s so different from the 1970s? A structural interpretation of changes in the macroeconomy effects of oil prices” NBER Working Paper 15467.

Galí Jordi and Thijs Van Rens, (2009): "The Vanishing Procyclicality of Labour Productivity and the Great Moderation", mimeo.

Killian, Lutz (2007), “The economic effects of energy price shocks”, VoxEU.org, 13 November.

Kilian, Lutz (2009), “Not All Oil Price Shocks Are Alike: Disentangling Demand and Supply Shocks in the Crude Oil Market”, The American Economic Review.

Lippi, Francesco (2008), “Oil prices: Risks and opportunities”, VoxEU.org, 11 June.

Lippi, Francesco and Andrea Nobili (2008), “Oil and the Macroeconomy: A quantitative structural analysis”.

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