The visible hand in economics

Oil shocks

Posted on: October 30, 2007

Time is tight so I can’t do a real blog post just now. However, I thought I could mention oil shocks and the difference between their impact in the 1970’s and now.

Oil prices have gone through the roof in recent times as a result of high world prices. In 2006, New Zealand was also suffering from its own oil shock, with world prices high and our dollar falling. However, we haven’t really seen much of an impact on the domestic economy, other than a slight fall off in domestic consumption. Compare this to the 1970’s, when oil shocks caused periods of massive inflation, forcing economists to see that the Phillips curve idea didn’t hold up in a dynamic setting.

Greg Mankiw goes on to discuss three reasons why oil shocks haven’t lead to massive inflation (note that the current oil shock will be severe in the USA, as their dollar has fallen strongly and world prices have risen):

  1. The economy is more energy-efficient
  2. Labour markets are more flexible, monetary policy has been designed better
  3. The inflationary impact of an oil price shock is different when it is the result of greater demand for oil (as it is currently) compared to the 1970’s when their was a cut in the supply of oil.

If I find time, I might try to talk about these issues, and how I think oil price shocks influence the NZ economy, but don’t count on it 🙂 . So, does anyone have anything to say about oil price shocks (preferably not about peak oil, but if you really have to 🙂 )

Update: There was a fourth reason in the Mankiw article. 4) The increase in oil prices was not as sudden, giving economic variables the chance to adjust (this concept comes from his New Keynesian belief in sticky wages and prices).

Update 2: Even NZPA has something to say about Oil prices and inflation, it might be a hot topic.

Update 3: Looks like the topic of Oil prices is making its rounds on the blogsphere. With US economic growth at 3.9% (this is an annualised rate, it is equivalent to have just under 1.0% quarterly growth in terms of how we measure GDP in NZ) with these high oil prices, it looks like this will be an important and interesting issue.

7 Responses to "Oil shocks"

We got used to oil at $65 a barrel fairly quickly, and we will get used to it at $100 a barrel fairly quickly too. But $102.47, now THAT is the scary number.

I think people are starting to see that arbitrary benchmarks are meaningless, but that doesnt stop the hype. In Australia the big thing in the next few months will probably be the Ones.

$1 parity with the USD, $100 a barrel for oil, and $1000 for gold.

While higher oil prices probably aren’t as big a problem as they used to be, the issue may be is this just one economic nasty too many right now .

Could it be the squeeze on US consumer spending (especially if there’s a cold northen winter) that in addition to reduced wealth effect caused by falling house prices tips things into recession?

Interesting post Matt – your thoughts made me post a blog post about this myself (

I guess my concern whenever the oil shocks of 73 are brought up, there is sometimes snide commentary around it that the severity of the shocks was partially because of the popularity of Keynesian/quasi-corporatist policies and mixed economies. In my opinion, all the oil crisis did was prove beyond any reasonable doubt how economically irrational and politically destabilising it was to be supporting Israel at the time.

Very interesting points everyone.

I am definitely looking forward to AUD/USD parity Kimble, since the NZD follows the AUD it will definitely improve my purchasing power 🙂

Richard, it will be interesting to see how things pan out. The lower wealth effect from falling house prices, along with a jump in fuel bills should be hammering US consumers. However, the September GDP number shows that they have been performing quite well. Ultimately, I’d like to see more data on consumers liquidity in the US, maybe they have access to a better portfolio of assets then we give them credit for?

Oliver, interesting post, I will comment on it at some point. Of the four points above (one was added in the update) my favorite would be the fourth one, that the oil price change hasn’t been as sudden and so institutions have been able to adapt. Although I think point 1 and 2 were probably useful (i’m not quite so sure if I by point 3, but I’m sure Mr Mankiw understands it better than I do).

I would be interested in hearing how you think the geo-political situation was different in the 1970’s and now, and how you think that may influence the severity of oil shocks. Do you think that the western world has a stronger bargaining position now?

“economically irrational and politically destabilising it was to be supporting Israel at the time.”

Financially irrational perhaps, but not economically irrational. And politcal stability is not all it is cracked up to be.

Old rationality. Either a subjective term, or meaningless, how I love using it :). I tend to use the term utility maximising instead. I’ve even got a t-shirt that has UTILITY MAXIMISER written on it.

Ahhh I love economics 😉

Cheers for your comments on my blog Matt – I’ll respond to those ones separately to the ones here. I admit that I am guilty (though no more so than many economists in my opinion) of making the totally normative assumptions about rationality with regard to Israel.

At the time, we need to remember that non-OAPEC (the Arab nations in OPEC) production was incredibly low compared to today. The Soviet Union in 1973, and even throughout the rest of the 70s, had far less of a proportion of the worlds oil production as the nations of the former Soviet Union do today. Because of the abundance of cheap oil from the Middle East, oil diversification strategies in countries like the US and NZ had yet to begin, and it was taken as a given that the relative stable nations of Iraq and Iran would continue to increase their output for Western oil users.

Supporting Israel during the Yom Kippur War in 1973 (where the United States was literally flying military hardware into Israel as Syrian and Egyptian forces looked like they were going to make it to Jerusalem) cost the West a very, very, very large amount of money. And that was in terms of military and economic aid, not the cost of the oil embargo (which was 100% due to American and other Western nations supporting Israel). Now I’m not making value judgements here about whether in the long run it was a good thing (I’m a supporter of the existence of Israel), but I’m just pointing out at the time in the medium term it was a huge cost on the economies of the Western world and a very severe destabilising influence on the politics of the Middle East.

But yes, Matt, I do think the West has a much stronger bargaining position today. Even though in theory it looks like it might be worse owing to more assertive ‘anti-Western’ governments, in reality everyone apart from Iraq (and Iran if the USA provokes a conflict) is going to continue exporting oil in full knowledge that the United States and NATO would be willing to flex their muscles in case of any seriously dodgy dealings with oil prices and production beyond the normal cartel behaviour of OPEC.

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