In recent years, our understanding of the nature
of energy price shocks and their effects on the economy has evolved
dramatically. Only a few years ago, the prevailing view in the literature
was that at least the major crude oil prices increases were exogenous with
respect to the OECD economies and that these increases were caused by oil
supply disruptions triggered by political disturbances in the Middle East.
This view has little empirical support. Likewise, the popular notion that
OPEC constitutes a cartel that controls the price of oil has not held up
to scrutiny. At the same time, there has been increasing recognition of
the importance of shifts in the demand for oil. Recent research has
provided robust evidence that oil demand shocks played a central role in
all major oil price shock episodes since the 1970s.
There is no consensus in the literature on how to model the global market
for crude oil. One strand of the literature views oil as an asset, the price
of which is determined by desired stocks. In this interpretation, shifts in
the expectations of forward-looking traders are reflected in changes in the
real price of oil and changes in oil inventories. The other strand of the
literature views the price of oil as being determined by shocks to the flow
supply of oil and flow demand for oil with little attention to the role of
inventories in smoothing oil consumption.
Recent research shows that shocks to the flow supply of crude oil overall
have had little impact on the real price of oil since 1973. In contrast,
shocks to the flow demand for oil associated with the global business cycle
have been responsible for long swings in the real price of oil, notably in
1973/74, 1979/80 and 2003-2008. In addition, speculative demand shocks
defined as any demand shock that reflects forward looking behavior by
traders played an important role in 1979 (following the Iranian Revolution),
in 1986 (following the collapse of OPEC), in 1990/91 (following the invasion
of Kuwait), in 1997-2000 (following the Asian crisis) and in late 2008
(during the global financial crisis). Unlike shocks to the flow demand or
flow supply, speculative demand shocks can cause large immediate effects on
the real price of oil, for example in response to geopolitical events.
Although speculative trading appears to have played an important role in
some historical episodes, there is no evidence that it caused the surge in
the real price of oil during 2003-06 and only very limited evidence that it
helps explain the 2007-08 oil price surge. Instead, the bulk of the 2003-08
increase in the real price of oil was caused by fluctuations in the global
business cycle, driven in large part by unexpected growth in emerging Asia
superimposed on strong growth in the OECD. As the world economy collapsed in
late 2008, so did the real price of oil. More than half of the observed
decline in the real price of oil, however, was driven by expectations about
a prolonged global recession. The gradual recovery of the real price of oil
in 2009 can be attributed equally to a partial reversal of these
expectations and to a recovery of the demand for industrial commodities,
reflecting the improved state of the global economy.
The distinction between different oil demand and oil supply shocks has
far-reaching implications because each shock has different effects on the
U.S. economy and on the real price of oil. In addition, not all such shocks
are unambiguously harmful to oil importing economies. For example, shocks to
the global flow demand for oil have both a stimulating effect on the U.S.
economy and adverse effects on economic growth working through higher oil
prices in particular and higher industrial commodity prices more generally.
Empirical estimates suggest that, in the short run, the positive effects on
the U.S. economy are strong enough to sustain growth, while global commodity
prices are slow to respond and the world economy is booming. Only
subsequently U.S. real GDP gradually declines, as commodity price increases
gain momentum and the economic stimulus from higher global demand weakens.
This response pattern differs sharply from the typical effect of higher
energy prices driven by shocks to the speculative demand for crude oil, for
example, or by shocks to the flow supply of crude oil, but it helps explain
why the 2003-08 surge in the real price of oil did not create a major
recession long before the global financial crisis.
One direct implication of recent models of the endogenous determination of
the real price of oil is that conventional estimates of the response to
unanticipated oil price changes are best thought of as the response to an
average oil price shock and in practice may be sensitive to the sample
period, as the composition of the underlying demand and supply shocks
evolves over time. This helps understand why regressions of macroeconomic
aggregates on oil prices tend to be unstable over time and in particular why
the average effect of oil price shocks appears to have diminished since the
A second implication is that it is not logically possible to attribute the
macroeconomic effects associated with an oil price shock to the observed
change in the real price of oil. This would be misleading because the
ceteris paribus assumption is violated. It is more appropriate to think of
oil price fluctuations as symptoms of the underlying oil demand and oil
supply shocks. This calls for a fundamental change in the way policymakers
and economists think about the relationship between oil price volatility and
economic outcomes. For example, one cannot assess the causal effects of the
oil price increase of 2003-08 on the global economy because much of that oil
price increase was caused by strong growth in the global demand for
industrial commodities in the first place. In contrast, a better-posed
question would be how the growth in emerging Asia has affected the economic
performance of OECD economies both directly through trade and financial
asset market channels and indirectly through rising commodity prices.
Third, standard theoretical models of the transmission of oil price shocks
that maintain that everything else remains fixed, as the real price of
imported crude oil increases, are misleading and must be replaced by models
that allow for the endogenous determination of the price of oil rather At
this point we are only beginning to understand the theoretical implications
of endogenizing the real price of oil.
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