The Effects of Oil Shocks on the Economy: A Review of the Empirical Evidence

Publication Date: January 2006

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Economics

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Abstract:

Congress is concerned with preventing economic recessions and mitigating the effects of recessions. Eight of the nine post-war recessions were accompanied by sharp increases in the price of oil. The last four recessions followed this pattern: the 1973-1975 recession followed the oil embargo; the double dip recession of 19801982 followed the second oil shock, which was caused by the Iranian revolution and Iran-Iraq War; the 1990-1991 recession followed the oil price spike induced by the Gulf War; and the 2001 recession followed a sharp rise in oil prices from 1999 to 2000. Policymakers are concerned that the recent rise in oil prices could again spillover into the wider macroeconomy.

The coincidence of recessions and oil shocks does not prove that oil price changes have any effect on the economy. To make that case, one must use statistical methods to hold other economic factors constant. This report surveys the econometric literature on oil shocks to provide quantitative estimates of how large an effect oil price changes have on economic activity. It also reviews the statistical robustness of these findings and discusses some of the limitations of these types of statistical analyses.

Economic theory suggests that oil shocks lead to higher inflation, a contraction in output, and higher unemployment in the short run. It is the rise in energy prices, rather than "high" energy prices, that causes these macroeconomic problems. Effective policy responses are difficult because expansionary policy would exacerbate the inflationary pressures whereas contractionary policy would exacerbate the contraction in output.

There is a fair degree of consensus surrounding the range of estimates: for comparable studies, the cumulative effect of a 10% increase in oil prices during a one-quarter (3 month) period would be to reduce economic output by 0.2-1.1% over the next year from its baseline level. The magnitude of these estimates suggests that normal fluctuations in the price of oil would cause only minor fluctuations in economic growth. However, the estimates suggest that major oil shocks, in which oil prices rise for several consecutive quarters, often by more than 10% per quarter, could lead to recessions, all else equal. Some of the findings are not statistically robust. A few studies dissent from these findings.

Many studies find that the effects of oil on economic activity are waning. For example, a 2004 study found that a 10% increase in oil prices would only reduce GDP by 0.2% in 1998. Surprisingly, many studies found oil to have had stronger economic effects before the mid-1970s, although the major post-war oil shocks occurred since the mid-1970s. The studies suggest that the relationship between oil prices and economic activity is not a simple linear one (e.g., episodic oil price declines have negligible economic effects), but there is no straightforward way to identify a more accurate relationship.

This report will be updated as new research becomes available.