Oil price shock recession? Not this time, says BSE Affiliated Professor Jordi Galí

Though oil prices have recently set new inflation-adjusted records, the economic impact has not been nearly as damaging as during previous highs reached nearly three decades ago, says BSE Affiliated Professor and CREI Researcher Jordi Galí.

From a macroeconomic perspective, oil price shocks have a stagflationary effect on the economy of an oil importing country, causing growth rates to slow while price levels rise. In some cases, such as in separate instances in 1973 and 1979, oil price shocks have caused recessions and increases in the inflation rate.

In October, the price of oil surpassed the inflation-adjusted highs hit in early 1980. Depending on the adjustment, a $38 barrel of oil then would be worth $96 to $101 or more today. However, while the escalating crude prices have resulted in higher costs for gasoline and other energy goods, the current oil price shock has disrupted the world economy less than in the past.

According to Professor Galí, the reason for the relatively diminished impact is that “the recent increase has not been so sudden and, at least outside the U.S., its impact has been mitigated by the depreciation of the dollar”. As a result, the economy is less vulnerable to oil price shocks than it has been in the past.

An analysis of the key elements that determine the effects of an oil price shock are revealed in Professor Galí’s new paper, “The Macroeconomic Effects of Oil Price Shocks: Why are the 2000s so different from the 1970s?” joint with MIT Economist Olivier Blanchard. In it, they outline the different responses of US inflation and GDP to oil price shocks pre-1984 and post-1984, and investigate potential causes of the variations.

BSE Affiliated Professor and CREI Director Jordi Galí

Results obtained by Professors Galí and Blanchard, both of whom hold posts at the US National Bureau of Economic Research, indicate that at least four factors have played a role in mitigating the effects of the oil price shock on inflation and economic activity. The key factors are: smaller share of oil in production, more flexible labor markets, improvements in monetary policy, and, simply put, good luck.

Applying these determinants to the current situation reveals an explanation as to why the present rising oil prices has had a diminished effect in comparison to preceding shocks. Says Professor Galí, “in comparison to the 1970’s, the share of oil in consumption and firms' costs is smaller now. Second, real wages are more flexible, largely due to the absence of generalized indexation clauses that were popular in the 1970s. Finally, central banks are more credibly committed to keeping inflation low and stable”.

“As a result, inflation expectations have remained anchored at low levels, which has made it easier for central banks to keep inflation under control without the need of a recession”, Professor Galí concludes. These combined factors have created a modern economy better able to absorb the rise in the relative price of energy.

In addition to being an Affiliated Professor at the BSE and Professor at the UPF, Jordi Galí, is Director of the Centre for Research in International Economics (CREI), one of the BSE’s supporting academic institutions. He has been cited as the most productive Spanish researcher from 1990-2004, according to a study included in “Publishing Performance of Spanish Academics: 1970-2004” by D. Rodriguez (Spanish Economic Review, 2006).

A Fellow of the Econometric Society and member of the Council of the European Economic Association, he also holds Research positions at the Center for Economic Policy Research (CEPR) in London, and at the US National Bureau of Economic Research (NBER). His research centers on the areas of international and macroeconomics, particularly topics such as business cycles, inflation, exchange rates and the conduct of monetary policy.

See Prof. Galí's biography