Do We Really Know that Oil Caused the Great Stagflation? A Monetary Alternative

This PDF is a selection from a published volume

from the National Bureau of Economic Research

Volume Title: NBER Macroeconomics Annual 2001,

Volume 16

Volume Author/Editor: Ben S. Bernanke and Kenneth

Rogoff, editors

Volume Publisher: MIT Press

Volume ISBN: 0-262-02520-5

Volume URL: http://www.nber.org/books/bern02-1

Conference Date: April 20-21, 2001

Publication Date: January 2002

Title: Do We Really Know that Oil Caused the Great

Stagflation? A Monetary Alternative

Author: Robert B. Barsky, Lutz Kilian

URL: http://www.nber.org/chapters/c11065

Robert

B.

Barsky

and

Lutz Kilian

UNIVERSITY

OF

MICHIGAN AND

NBER;

AND

UNIVERSITY OF

MICHIGAN,

EUROPEAN CENTRAL

BANK,

AND CEPR

Do

We

Really

Know

that

Oil

Caused

the

Great

Stagflation?

A

Monetary

Alternative

1.

Introduction

There

continues to be considerable

interest,

both

among policymakers

and

in

the

popular press,

in

the

origins

of

stagflation

and the

possibility

of its recurrence.

The traditional

explanation

of the

stagflation

of the

1970s found

in

intermediate textbooks is

an adverse shift

in

the

aggregate

supply

curve that lowers

output

and

raises

prices

on

impact.1

Indeed,

it

is

hard to see

in

such

a

static

framework how

a

shift

in

aggregate

demand

could have induced

anything

but a

move of

output

and

prices

in

the

same direction. This fact has lent credence to the

popular

view

that

exogenous

oil

supply

shocks

in

1973-1974

and 1978-1979 were

primarily

responsible

for

the

unique experience

of the 1970s

and

early

1980s.

For

example,

The

Economist

(November

27,

1999)

writes:

Could

the

bad

old

days

of inflation be about to return? Since OPEC

agreed

to

supply-cuts

in

March,

the

price

of crude oil has

jumped

to almost

$26

a

barrel,

up

from

less

than

$10

last December

and

its

highest

since the Gulf

war in

We

have benefited from comments

by

numerous

colleagues

at

Michigan

and

elsewhere.

We

especially

thank

Susanto

Basu,

Ben

Bernanke,

Olivier

Blanchard,

Alan

Blinder,

Mark

Gertler,

Jim

Hamilton,

Miles

Kimball,

Ken

Rogoff,

Andre

Plourde,

Matthew

Shapiro,

and

Mark

Watson. We

acknowledge

an

intellectual debt to

Larry

Summers,

who stimulated our

interest

in

the

endogeneity

of oil

prices.

Allison

Saulog

provided

able

research assistance.

Barsky

acknowledges

the

generous

financial

support

of the Sloan

Foundation. The

opin-

ions

expressed

in

this

paper

are those of the authors and do not

necessarily

reflect

views of

the

European

Central

Bank.

1.

For

example,

Abel

and

Bernanke

(1998,

p.

433)

write that-after a

sharp

increase

in

the

price

of

oil-"in the short run

the

economy

experiences stagflation,

with

both a

drop

in

output

and a

burst

in

inflation."

138

*

BARSKY & KILIAN

1991.

This

near-tripling

of oil

prices

evokes

scary

memories

of the 1973 oil

shock,

when

prices

quadrupled,

and

1979-80,

when

they

also almost

tripled.

Both

resulted

in

double-digit

inflation

and

global

reces-

sion.

. .

.

Even

if

the

impact

will

be more

modest

this

time than

in

the

past,

dear

oil

will

still leave some mark.

Inflation will

be

higher

and

output

will

be

lower

than

they

would be

otherwise.

Academic

economists,

even

those who

may

not

fully agree

with

the

prevailing

view,

have done

little to

qualify

these

accounts

of

stagflation.

On

the

one

hand,

the recent

scholarly

literature has

focused on the

relationship

between

energy

prices

and

economic

activity

without

explic-

itly addressing stagflation

(see,

e.g., Hamilton,

1983, 1985, 1988, 1999;

Rotemberg

and

Woodford,

1996).

On the

other

hand,

some

authors

(e.g.,

Bohi, 1989;

Bernanke,

Gertler,

and

Watson,

1997)

have stressed not

the direct effects of oil

price

increases on

output

and

inflation,

but

possi-

ble indirect effects

arising

from the

Federal

Reserve's

response

to the

inflation

presumably

caused

by

oil

price

increases.

A

common

thread

in

the

popular press,

in

textbook

treatments,

and

in

the academic literature is that oil

price

shocks are

an

essential

part

of

the

explanation

of

stagflation.

In

contrast,

in

this

paper

we

make the case

that

the oil

price

increases were

not

nearly

as essential a

part

of

the

causal mechanism

generating

the

stagflation

of the 1970s as is often

thought.

We discuss reasons for

being skeptical

of the

importance

of

commodity

supply

shocks

in

general,

and the 1973-1974 and

1979-1980

oil

price

shocks

in

particular,

as the

primary explanation

of the

stagfla-

tion

of the 1970s.

First,

we show that there

were

dramatic and

across-

the-board

increases

in

the

prices

of industrial

commodities

in

the

early

1970s

that

preceded

the OPEC oil

price

increases. These

price

increases

do

not

appear

to be related to

commodity-specific supply

shocks,

but

are

consistent

with an

economic

boom fueled

by monetary expansion.

Sec-

ond,

there

is

reason

to doubt

that

the observed

high

and

persistent

inflation

in

the deflator

in

the

early

and late 1970s can be

explained

by

the 1973-1974

and

1979-1980 oil

price

shocks.

The

argument

that

oil

price

shocks caused

the Great

Stagflation depends

on the

claim

that

oil

price

shocks

are

inflationary. Using

a

simple

model,

we show

that

a

one-

time oil

price

increase

will

increase

gross output price

measures such

as

the

CPI,

but not

necessarily

the

price

of value

added,

as

proxied

by

the

GDP

deflator.

Indeed,

an

oil

price

increase

may

lower

the deflator.

Fur-

ther,

the

data show

that

only

two

of

the

five

major

oil

price

shocks

since

1970

have been followed

by significant changes

in

the inflation

rate of

the GDP

deflator,

though

in all

cases the CPI

inflation rate

changed

sharply

relative to the deflator.

Although

we

come

to the same conclu-

Do

We

Really

Know

that Oil Caused

the Great

Stagflation?

*

139

sion as Blinder

(1979)

that oil caused

a

spike

in

consumer-price

inflation

during

the two most

stagflationary

episodes,

we

show

that oil

prices

do

not

provide

a

plausible explanation

of

the

sustained

inflation that

oc-

curred

in

the GDP deflator as

well

as in the

CPI.

If

oil

price

shocks were not

the

source of the Great

Stagflation,

what

explains

the

striking

coincidence

of

the

major

oil

price

increases

in

the

1970s

and

the

worsening

of

stagflation?

In

this

paper

we

provide

evidence

that

in

the 1970s the rise

in

oil

prices-like

that

in

other

commodity

prices-was

in

significant

measure

a

response

to macroeconomic

forces,

ultimately

driven

by

monetary

conditions. This view coheres well

with

existing

microeconomic theories about the effect of real-interest-rate

varia-

tion

and

output

movements

on

resource

prices,

and

challenges

the con-

ventional wisdom

that

major

oil

price

changes

are

largely exogenous

with

respect

to

macroeconomic variables of OECD

countries.

It is

commonly

held

that

major

oil

price

movements are

ultimately

due to

political

events

in

the

Middle East. Our

analysis

suggests that-although political

factors

were

not

entirely

absent from

the

decision-making

process

of OPEC-the

two

major

OPEC

oil

price

increases

in

the 1970s would have been far less

likely

in

the

absence of conducive macroeconomic

conditions

resulting

in

excess

demand in

the

oil

market.

The

prevailing

view that

exogenous

oil

price

shocks were the

primary

culprits

of

the Great

Stagflation

of the

1970s

goes

hand

in

hand

with

the

perception

that

monetary

factors

do

not

provide

an

adequate explanation

of

stagflation.

In

this

paper

we

develop

more

fully

a

latent

dissent to

the

conventional

view that

monetary

considerations

cannot account for

the

historical

experience

of the 1970s.2

Bruno and

Sachs

(1985)

and,

to

a

lesser

extent,

Blinder

(1979,

p.

77)

discuss

monetary

expansion

as one

impor-

tant

source of

stagflation,

but their

emphasis

is

on the

inadequacy

of

money

as an

explanation

of

the bulk

of

stagflation

and

commodity price

movements.3 In

contrast,

we

show how

in

a

stylized

dynamic

model

of

the

macroeconomy stagflation

may

arise

endogenously

in

response

to

a

sustained

monetary

expansion

even in

the

absence of

supply

shocks.

The

data

generated

by

the

model

are

broadly

consistent,

both

qualitatively

2.

References that

we

identify

with the

traditional view

include

Samuelson

(1974),

Blinder

(1979),

and

Bruno and

Sachs

(1985).

Precursors of our

alternative

explanation

of

stagfla-

tion and its

association with oil

prices

include Friedman

(1975),

Cagan

(1979),

McKinnon

(1982),

Houthakker

(1987),

and

De

Long

(1997).

3.

For

example,

Bruno and

Sachs

(1985,

p.

6)

stress

the

inadequacy

of

purely

demand-side

models of

stagflation

and

propose

that

contractionary

movements in

aggregate

supply

(such

as

oil

price

shocks)

are

needed

to

explain

the

slide into

stagflation.

Blinder

(1979,

pp.

102,

209)

states that

the

inflation

of

1973-1974

was

simply

not

a

"monetary

phenome-

non." As

the causes of

the

inflationary surge

in

the

mid-1970s,

and

also

of the

recession

that

followed,

he

identifies

"special

factors"

such as

food

price

shocks

in

1972-1974,

the

oil

price

shock

in

1973,

and

the

dismantling

of

price

controls

in

1974.

140

*

BARSKY &

KILIAN

and

quantitatively,

with

the

dynamic properties

of

the actual

output

and

inflation data

for

1971-1975.

Our model

captures

the notion

that

eco-

nomic

agents

in

the 1970s

responded only

gradually

to

shifts

in

the mone-

tary policy

regime.

We

link

these shifts to the breakdown of the Bretton

Woods

system

and to

changes

in

policy

objectives.

Several indicators

of

monetary

policy

stance show

that

monetary policy

in

the

United

States,

in

particular,

exhibited

a

go-and-stop pattern

in

the 1970s.

Moreover,

episodes

of

stagflation

were associated

with

swings

in

worldwide

liquid-

ity

that

dwarf

monetary

fluctuations elsewhere

in

our

sample.

The

remainder of

the

paper

is

organized

as follows.

We

begin

with an

outline

of

the

basic facts of the

stagflation

of

the

1970s

in

Section

2.

Section

3

presents

a

monetary

explanation

of

stagflation.

In

Section

4

we

examine

the

empirical support

for this

monetary explanation,

and

in

Section

5 the

reasons for

the shifts

in

monetary

policy

stance

that

in

this view

ulti-

mately triggered

the Great

Stagflation.

In

Section

6 we discuss theoretical

and

empirical

arguments against

the

oil-supply-shock

explanation

of

stag-

flation.

Finally,

in

Sections

7 and

8 we discuss the theoretical reasons

for

a

close

relationship

between

oil

prices

and macroeconomic

variables

and

provide

evidence

that oil

prices

were

in

substantial

part

responding

to

macroeconomic

forces,

rather

than

merely

political

events

in

the

Middle

East. Additional

evidence

from the most recent

oil

price

increase

is dis-

cussed

in

Section

9. Section

10 contains the

concluding

remarks.

2. Basic

Facts

This

section

describes some

of

the salient features

of

stagflation

and of

the

evolution

of oil

prices

in the

postwar period.

The 1970s

and

early

1980s

were

an

unusual

period

by

historical

standards.

Table

1

describes

the

pattern

of

inflation

and of GDP

growth

for each

of the

NBER

business-cycle

contractions

and

expansions.

For each

phase,

we

present

data on nominal

GDP

growth

and its breakdown

into real

and

price

components.

Two

critical observations

arise

immediately

from

Table

1.

First,

with one

exception,

the

phase

average

of the

rate of

inflation

rose

steadily

from

1960.2

to

1981.2,

and

declined

over

time

thereafter.

The

exception

is that

inflation

was 2.5

percentage

points

lower

(9.56%

com-

pared

with

6.98%)

during

the 1975.1-1980.1

expansion

than

in

the

pre-

ceding

contraction

period

from 1973.4

to

1975.1.

The

second,

and most

important,

observation

is

the

appearance

of

stagflation

in

the

data.

Stagflation

appears

in

Table

1

as

an

increase

in

inflation

as

the

economy

moves

from an

expansion

to

a

contraction

phase.

There

were

three

episodes

in

which

inflation,

as

measured

by

the

growth

in

the GDP

deflator,

was near

9%

per

annum.

In

two of

these

Do We

Really

Know that Oil Caused

the

Great

Stagflation?

*

141

Table

1 REAL

GROWTH, INFLATION,

AND NOMINAL

GROWTH

IN

THE

UNITED STATES

NBER business-

State

of

the

Percent

change per

annum

NBER business-

State

of

the

cycle

dates

economy

Real

growth Inflation

Nominal

growth

1960.2-1961.1

Contraction

-1.03

+1.22

+0.19

1961.1-1969.4

Expansion

+4.64

+2.59 +7.23

1969.4-1970.4

Contraction

-0.49

+4.93

+4.44

1970.4-1973.4

Expansion

+4.34

+5.22 +9.56

1973.4-1975.1 Contraction

-1.76 +9.56

+7.80

1975.1-1980.1

Expansion

+3.80

+6.98 +10.78

1980.1-1980.2 Contraction

-3.46 +8.88 +5.42

1980.2-1981.2

Expansion

+0.62

+9.11 +9.73

1981.2-1982.4 Contraction

-1.34

+6.07 +4.73

1982.4-1990.2

Expansion

+4.07 +3.29

+7.36

1990.2-1991.1 Contraction

-1.27

+4.12

+2.85

1991.1-2001.1

Expansion

+3.46

+2.10 +5.56

Source: Based on

quarterly chain-weighted

GDP

and

GDP

deflator data from

DRI

for 1960.1-2001.1. The

business-cycle

dates

are based on the NBER

dating.

The last

expansion

is

incomplete.

three

episodes

real

output

contracted

sharply

(i.e.,

in

1973.4-1975.1

and

1980.1-1980.2),

and

in

the

third it

grew

very

slowly

(i.e.,

in

1980.2-

1981.2).

Indeed,

in

all but

one contraction

(i.e.,

with

the

exception

of the

second Volcker recession

in

1981.2-1982.4),

average

inflation

during

the

contraction was

higher

than

during

the

Figure

1

shows the

percentage change

in

the nominal

price

of

oil since

March

1971,

when

the

U.S. became

dependent

on oil

imports

from the

Middle East

(see

Section

8).

Episodes

of so-called oil shocks are

indicated

by

vertical bars

and

include the 1973-1974 OPEC oil

price

increase

after

the October

war

of

1973,

the 1979-1980

price

increases

following

the

Iranian

revolution

in

late 1978 and the

outbreak of the

Iran-Iraq

war

in

late

1980,

the

collapse

of OPEC

and

of the oil

price

in

early

1986,

the

oil

price spike

following

the invasion of Kuwait

in

1990,

and

the most

recent

period

of

OPEC

price management

since March 1999.

The

coincidence of

two

large

increases

in

the

price

of

imported

oil

in

the

1970s

and

two

periods

of

strong stagflation

has

spurred

interest

in

a

causal link

from

"oil

shocks" to

stagflation,

although

casual

inspection

of

Figure

1

and

Table

1

suggests

that

this

link

is

far

less

apparent

for other

episodes.

The

decade of

the 1970s also

coincided

with

fundamental

changes

in

monetary policy

and in

attitudes

toward

inflation,

as the Bretton

Woods

system

collapsed.

Monetary policy

became much

more

expansionary

on

average

and

more

unstable

in

the

1970s

than in

the

1960s. One

reason

that

these

developments

are

often

considered less

important

in

discus-

142

*

BARSKY

&

KILIAN

Figure

1

PERCENTAGE CHANGE IN NOMINAL

PRICE

OF OIL

50-

40-

30-

20-

10-

0

-10-

-20-

-30

-

-40-

-50

Source:

The

underlying

oil

price

series is

refiner's

acquisition

cost of

imported

crude

oil

(DRI

code:

EEPRPI)

for

January

1974 to

July

2000. We use the U.S.

producer

price

index for oil

(DRI

code:

PW561)

and

the

composite

index for refiner's

acquisition

cost of

imported

and domestic

crude oil

(DRI

code:

EEPRPC)

to

extend

the data

back

to March

1971.

sions

of

stagflation

is the

perception

that

monetary

factors are

unlikely

to

generate stagflation

of sufficient

magnitude

(see

Blinder,

1979).

As

we

will

show

in

Section

3,

this

perception

is incorrect. Another reason for

the

popularity

of

the

oil-price-shock

explanation

of

stagflation

is

the

fact that

both

the

phenomenon

of

stagflation

and that

of

major

upheavals

in

the oil

market

occurred for the

first

time

in

the

1970s,

although

Table 1

suggests

that

stagflation predates

the

first

oil

price

shock

of late

1973.

Although

oil

price

shocks continue

to

occur,

there

have been

no

major episodes

of

stagflation

since the 1970s.

In

this

paper

we

question

the

extent

to

which

we

really

know

that oil

price

shocks

played

a

central role

in

generating

stagflation.

We

will

show

that a

monetary

approach

can

explain

not

only

the

evolution of

the

Great

Stagflation,

but

also

that of

the

price

of

oil

during

that

period.

We

will

present

a

coherent

explanation

for the

almost simultaneous occurrence

I

Do We

Really

Know

that Oil

Caused

the Great

Stagflation?

*

143

of

high

oil

prices

and

stagflation

in

the

1970s,

and

for the absence

of

such

a

relationship

in

subsequent

periods.

3.

Purely Monetary Explanation

of

the

Great

Stagflation of

the 1970s

In

this

section,

we

describe

a

stylized

monetary

model

that

illustrates

how

substantial

stagflation may

arise even

in

the

absence of

supply

shocks

when

inflation is

inherently

"sluggish"

or

persistent,

and

particularly

when

the

monetary

authority

also

follows

a

rule

that

prescribes

a

sharp

contractionary

response

to increases in inflation.

In

this model

as well

as

in

the

data,

inflation

continues to rise after

output

has

reached

its

maxi-

mum and

peaks

only

with a

long

delay. Impulse-response

estimates

from

structural

vector

autoregressions

(VARs)

indicate

that a

monetary expan-

sion is

followed

by

a

prolonged

rise not

just

in

the

price

level,

but in

inflation,

a

phenomenon

that

Nelson

(1998)

calls

"sluggish

inflation."

Likewise,

it is

widely

accepted

that

output

exhibits

a

hump-shaped

re-

sponse

to

a

monetary

expansion.

An

important empirical

regularity

in

VAR

studies is that the

response

of

output

peaks

after about

4-8

quarters,

followed

by

a

peak

in

inflation

after about 9-13

quarters

(e.g.,

Bernanke

and

Gertler, 1995;

Christiano,

Eichenbaum,

and

Evans, 1996;

Leeper,

1997).

Thus,

the

peak

response

of

output

occurs about

one

year

before the

inflation

response

reaches its maximum.4

What

is the

source

of

sluggish

inflation?

Sluggish

inflation is

not

a

property

of

the most

commonly

used

monetary

business-cycle

models

(Taylor,

1979;

Rotemberg,

1982,1996;

Calvo,

1983).

In

these

models,

both

inflation

and

output jump

immediately

to their maximal

levels,

followed

by

a

monotonic decline.

Although

recent

research has

demonstrated the

inconsistency

of the

Taylor-Calvo-Rotemberg

model with

the

stylized

facts about

inflation

and

output dynamics

(see

Nelson,

1998),

it

has

not

provided

a

generally

appealing

alternative.

In

this

paper,

we take the

position

that

sluggish

inflation

reflects

the fact that

agents

learn

only

gradually

about shifts in

monetary

policy

(see

Sargent,

1998).

Agents

are

always

processing

new

information,

but

especially

so in a

period

follow-

ing regime

changes

as

dramatic as

the

changes

that

occurred

in

the

1970s.

Given the

low and

stable

inflation

rates of the

1960s,

it

is

plausible

that

agents

were slow

to

revise their

inflationary expectations

when

confronted

with an

unprecedented

monetary

expansion

under Arthur

Burns in

the

early

1970s.

This

interpretation

appears

even

more

plausi-

4.

Nelson

(1998)

presents

estimates that

the

response

of inflation

to a

monetary

innovation

peaks

after 13

quarters,

but

his VAR

only

includes

money

and

the

price

level.

144

*

BARSKY & KILIAN

ble

considering

the financial

turmoil and

uncertainty

associated

with

the

gradual

disappearance

of

the Bretton Woods

regime. Similarly, expecta-

tions

of

inflation

were slow to

adjust

in the

early

1980s,

when Paul

Volcker launched

a new

monetary policy regime resulting

in

much lower

inflation.

We

propose

a

stylized

model that

formalizes

the notion

that in times of

major

shifts

in

monetary policy

inflation is

likely

to

be

particularly slug-

gish.

Consider

a

population

consisting

of two

types

of

firms.

A

fraction

(,t

of

"sleepy"

firms is not convinced

that

a

shift

in

monetary

policy

has

taken

place

and

sets

its

output price

(pt)

at

last

period's

level

adjusted

for

last

period's

inflation

rate. The

remaining

fraction

1

-

w,

of "awake"

firms

is

aware of the

regime

change

and sets its

output

price

at

P?t

=

Pt

+

l3(Yt

-

yf),

where 8

is a

constant,

Yt

the

log

of real

GDP,

and

yf

the

log

of

potential

real GDP.

As time

goes

by,

the fraction

of

agents

that

is

un-

aware of

the

regime

change

evolves

according

to

wt

=

e-At.

These consider-

ations

imply

an

aggregate

price-setting equation

of

the form

Pt =

wtP

+ (1

- t)pt

=

e-'t

(2pt_1

-

Pt2)

+ (1

-

e-t)

[p,

+

(t

- yf)].

(la)

This

price

equation

is the source of

the inflation

persistence

in our

model.

Equation

(la)

is

very

much

in

the

spirit

of

Irving

Fisher's

(1906)

reference

to

an

earlier

monetary expansion

that

"caught

merchants

nap-

ping."

Its

motivation is closer

to that

of the Lucas

supply

schedule

(see

Lucas,

1972,

1973)

than

to that of

sticky-price

models.

Agents

are

always

free

to

adjust prices

without

paying

"menu costs."

Moreover,

by

the

choice

of

appropriate

time-varying

weights

wt,

our

inflation

equation

may

allow

for the

fact that

agents

learn more

quickly

about

some

shifts

in

policy

than about others.

For

expository

purposes,

however,

we

postu-

late

that these

weights

evolve

exogenously.

The second

building

block of

the model

is the

equation

Ayt

=

Amt

-

Apt,

(lb)

where

Apt

is

the

inflation

rate

(which

we

will

associate

with the rate of

change

of the GDP

deflator)

and

Amt

is the

rate of nominal

money

growth.

This

relationship

is

a

very

simple

money

demand

equation.

We

complete

the

model

by

adding

a

policy

reaction function.

We

posit

that

the Fed

cannot

observe

the current

level

of the

GDP

deflator.

We

postulate

a

reaction

function

under which

the

Fed

targets

the rate of

inflation.

Let

"-ew

be

the

steady-state

rate of inflation

consistent

with

the

initial

increase

in

money growth.

That

rate

may

be

interpreted

as

the

level of

inflation

that the Fed

is

willing

to tolerate

under

the new

expan-

Do We

Really

Know that

Oil Caused

the

Great

Stagflation?

?

145

sionary regime.

The Fed

responds

to

periods

of inflation

in excess of

,new

by decelerating

monetary growth by

some small fraction

y

of last

pe-

riod's excess

inflation rate:

A2mt

=

-y

Ap,_

I(Apt_1

>

fnw)

+

At,,

(Ic)

where

I(-)

denotes

the indicator

function,

and

Et

represents

the

increase

in

the

money

growth

rate

associated

with the Fed's more

expansionary

policy

after

the

collapse

of

the

Bretton Woods

system.

Note

that,

holding

constant other demand shifters

and

given

the

sluggishness

of

inflation,

this

money growth

rule

may

be translated into a more

conventional

interest-rate rule

by

inverting

an

IS curve

and

observing

that

high

real

balances

imply

low real interest rates.

In

addition,

by

way

of

compari-

son,

we

will

explore

a

much

simpler

model

in which

money supply

growth

follows

a

sequence

of

exogenous policy

shocks

Et

and

in

which

there

is no

policy

feedback:

A2mt

=

AEt. (lc')

The

model is

parametrized

as follows.

We

postulate

that

in

steady

state

output

grows

at

3%

per

annum.

Moreover,

prices

grow

at a

steady

rate of 3%

per

annum

prior

to the

monetary expansion.

We

follow

Kim-

ball

(1995)

in

setting

3

=

0.06. The

single

most

important parameter

in

the

model is

A,

which

determines the fraction of

agents

"awake." We

choose

A

to

give

our

model the

best

possible

chance to

match the

timing

of

business-cycle

peaks

and

troughs

in

the U.S. inflation and

output-gap

data

for 1971-1975.

The

resulting

value of

A

=

0.08

implies

that after

two

years

slightly

less

than

half of

economic

agents

will

have

adopted

the

new

pricing

rule.

This rate of

transition

may

appear

slow,

but-as we

will

discuss

below-is consistent with

evidence from other

sources as

well.5

Finally,

for

the model with

policy

feedback,

we

choose

y

=

0.05 for

illustrative

purposes.

This value

means

that, if,

for

example,

the inflation

rate last

quarter

is

2%,

the Fed will

decelerate

monetary growth

by

0.1

percentage point

(one-tenth

of

the initial

monetary expansion).

Our

choice of

y

ensures

that

the inflation

rate

returns to the initial

steady-

5.

In

our

model

it

takes about

two

years

for half

of the

agents

to

adopt

the

new

pricing

rule.

This

rate of

adaptation

may appear

very

slow,

but it

is not unlike

those found in

many

other

economic

contexts. For

example,

data

from

the literature on

the

entry

of lower-

priced

generics

into

the

market for

branded

drugs

show that

after two

years

only

about

half

of

the

consumers have

switched

to the

lower-priced generic

drug

(see

Griliches and

Cockburn, 1994;

Berndt,

Cockburn,

and

Griliches,

1996).

If

it

takes so

long

for

agents

to

adapt

in

such

a

simple problem,

it

does

not

appear implausible

that it

would

take

at

least

as

long

in

our

context.

146

*

BARSKY &

KILIAN

state rate

in

the

long

run.

This choice is consistent with the

interpreta-

tion

that the Fed-rather than

discovering

a solution to

the

dynamic

inconsistency

problem-found

its

way

back to low inflation

using

a

mechanical

rule

(see

Sargent,

1998).

Given this choice

of

parameters,

consider

a

one-time shock

to

E,

in

period

5,

representing

a

4-percentage-point-per-annum

increase

in

money growth, beginning

in

steady

state.

Figure

2a

shows

that

a

mone-

tary expansion

produces

the

essential features discussed above.

The

model

economy displays stagflation, sluggish

inflation,

and a

hump-

shaped response

of

output

to a

monetary expansion.

Most

importantly,

the

output gap

rises

with

the inflation rate

initially,

with

output peak-

ing

about two

years

after the

shock,

whereas inflation

peaks only

after

three

years

(close

to

the 13

quarters reported by

Nelson,

1998).

Between

these

two

peaks

output

and inflation move

in

opposite

directions,

re-

sulting

in

stagflation.

We now address

the extent to which

this

stylized monetary

model

can

explain

the

business-cycle

peaks

and

troughs

over the 1971-1975

period.

Consider

the

following

thought experiment:

Since

we know

that

a

strong

monetary expansion

took

place starting

in

the

early

1970s,

we-somewhat

arbitrarily-propose

to date the

monetary expansion

in

the

model so

that

period

5

in

Figure

2a

corresponds

to

1971.1. This

thought experiment

allows

us

tentatively

to

compare

the behavior

of

output

and inflation

in

the model

in

response

to a

monetary

expansion

with the actual

U.S.

data.

Given

this

interpretation,

the

monetary

model

predicts

a

peak

in

GDP

in

1972.4-1973.1,

followed

by

a

peak

in

deflator

inflation

in 1974.2

(shortly

after the

OPEC oil

price

increase)

and

a

trough

in

GDP

in 1975.2. Note

that,

although

the

NBER

dates

the

end

of the

expansion

in late

1973,

Hodrick

and Prescott

(HP)

detrended

GDP

peaks

in

1973.1,

at

the same

time as

the

gap peaks

in

our model.

Thus,

the

timing

of the

cycle

that would

have

been

induced

by

the

monetary

expansion

in

1971.1

(after

allowing

for the

Fed's reaction

to

the

changes

in inflation set

in

motion

by

this

initial

expansion)

is re-

markably

close

to the

timing

of

the actual business

cycle.

Note that

this

coincidence

of

the

timing

of

the

business-cycle

peaks

and

troughs

does

not

occur

by

construction,

but arises

endogenously

given

our

choice

of

parameters.

Continuing

with

the

same

analogy,

we now

focus

on the

magnitude

of

the

output

and

price

movements

induced

by

the

monetary

expansion.

Of

particular

interest

is

the

ability

of the

model

to

match

the

phase

averages

for 1971.1-1973.3

and for

1973.4-1975.1.

We find that

the

aver-

age per

annum

inflation

rates

for

1971.1-1973.3

and

1973.4-1975.1

in

the

model

are

fairly

close

to

the U.S.

data.

The model

predicts

average

inflation rates

of

5.1%

and

10.4%

per

annum,

respectively,

compared

Do We

Really

Know

that

Oil

Caused

the Great

Stagflation?

*

147

Figure

2 IMPLICATIONS OF A PURELY MONETARY

MODEL OF

STAGFLATION:

(a)

WITH POLICY

FEEDBACK;

(b)

WITHOUT

POLICY

FEEDBACK

0.08

0.06-

,,"

',\

0.04-

0.02-

0.00--

\

-0.02-

-0.04

-

-0.06

5 10 15 20 25 30 35 40

(a)

0.08

0.06-

,,

x\

'"\

0.04-

0.02-

"

/

,

/zi

'

0.00

-----

-0.02-

-0.04

5 10 15

20 25 30

35

40

(b)

Notes: Solid

curves:

quarterly

inflation

rate.

Dashed curves:

output gap.

Models described in

text.

Responses

to

a

permanent

1-percentage-point

increase

in

money

growth

in

period

5.

148

*

BARSKY & KILIAN

with

4.9%

and

9.6%

in

the

data.

Thus,

both

the model and

the

data

show

a

substantial

increase

in

inflation

during

the

recession.

Similarly,

for

GDP

growth

the model fit

is not

far

off. The

model

predicts

4.8%

growth

per

annum for

1971.1-1973.3

compared

with 5.2% in

the

data,

and

-3.0% for

1973.4-1975.1

compared

with -1.8% in the data.

We

conclude

that the

quantitative

implications

of

this model are not

far

off

from

the U.S.

data,

especially

considering

that we

completely

ab-

stracted

from other

macroeconomic determinants. Also note

that the

Fed

inflation

target

in

our model

economy

becomes

binding

in

early

1973,

consistent

with the

empirical

evidence of

a

monetary

tightening

in

early

1973

in

response

to actual and

incipient

inflation

(see

Section

4).

This

example

illustrates

that

go-stop monetary

policy

alone could

have

generated

a

large

recession

in

1974-1975,

even

in

the

absence

of

supply

shocks.

A

question

of

particular

interest is how essential

the

endogenous pol-

icy

response

of the

Fed

is

for the

generation

of

stagflation.

Some authors

have

argued

that the

1974

recession

may

be

understood

as

a

conse-

quence

of

the Fed's

policy response

to

inflationary expectations

(e.g.,

Bohi,

1989; Barnanke,

Gertler,

and

Watson,

1997).

Figure

2b shows that

policy

reaction

is an

important,

but

by

no

means

essential,

element of

the

genesis

of

stagflation.

In

fact,

a

qualitatively

similar

stagflationary

episode

would

have

occurred

under the

alternative

policy

rule

(lc')

with-

out

any

policy

feedback. The

main

effect of

adding policy

feedback

(y

>

0)

is

to increase

the

amplitude

of

output

fluctuations

and

to

dampen

variations

in

inflation.

In

the model

without

policy

feedback,

holding

fixed

the

remaining

parameters,

the

timing

of the

cycle

induced

by

the

monetary

regime

change

is

roughly

similar

to

that

in

Figure

2a.

Figure

2b shows

a

peak

in

GDP

in

1972.4-1973.1,

followed

by

a

peak

in inflation

in

1974.3

and

a

trough

in

GDP

in

1975.2.

The model

without

policy

feedback

predicts

average

annual

inflation rates

of 5.1%

and 12.0% for

1971.1-1973.3

and

1973.4-1975.1,

respectively,

compared

with

4.9% and 9.6%

in the

U.S.

data.

Average

output growth

per

annum over

these same

subperiods

is

4.9%

and

-2.0%,

respectively,

in the

model,

compared

with 5.2%

and

-1.8%

in the data.

The

policy

shift

associated

with

the

monetary

tightening

under Paul

Volcker

in

late

1980

provides

a

second

example

of the

basic mechanism

underlying

our

stylized

model.

Using

the

same

parametrization

as

for

Figure

2b,

our model

predicts

a

sharp

recession

in

late

1982,

followed

by

an

output

boom

in

1985

and

an

output

trough

in

early

1987. This

pattern

closely

mirrors

the movements

of HP-filtered

actual

output.

At the

same

time,

inflation

in

the model falls

sharply,

reaching

its

trough

in

1984,

Do We

Really

Know

that

Oil Caused the Great

Stagflation?

*

149

followed

by

a

peak

in

1986. Actual inflation in the GDP

deflator

followed

a

qualitatively

similar,

but

delayed pattern.

It

reached

its

trough

in

1986,

followed

by

a

peak

in

mid-1988.

Thus,

the

response

of

actual inflation

in

this

episode

is even more

sluggish

than

that

in

the model.

4

Supportfor

the

Monetary

Explanation

of

Stagflation

In

this

section,

we

will

present

four

additional

pieces

of evidence

in

support

of

the

monetary

explanation

of

stagflation.

First,

we

will

exam-

ine several indicators

of

monetary

policy

stance to show

that

monetary

policy

in

the

United

States,

in

particular,

exhibited

a

go-and-stop pattern

in the

1970s.

Second,

we

will

show

that

episodes

of

"stagflation"

were

associated

with

swings

in

world-wide

liquidity

which dwarf

monetary

fluctuations elsewhere

in

our

sample.

Third,

we

will

show

that

there

were

dramatic and

across-the-board increases

in

the

prices

of

industrial

commodities

in

the

early

1970s

that

preceded

the OPEC

oil

price

in-

creases.

These

price

increases

do

not

appear

to be

related to

commodity-

specific supply

shocks,

but are

consistent

with

an

economic

boom

fueled

by monetary

expansion. Finally,

we

will

document

that

in

early

1973

a

broad

range

of

business-cycle

indicators started to

predict

a

recession,

nine

months before the

first OPEC

oil

crisis,

but

immediately

after

the

Fed

began

to

tighten

monetary policy.

4.1

EVIDENCE OF

GO-AND-STOP MONETARY

POLICY

IN THE

UNITED STATES

Our

evidence is based on two

measures of the total

stance of

monetary

policy

for this

period-one

based

on the behavior

of the Federal

Funds

rate,

the

other

based on

narrative evidence

(see

Bernanke

and

Mihov,

1998;

Boschen and

Mills,

1995).

The

Bernanke-Mihov index of

the over-

all

monetary

policy

stance shows

a

strongly

expansionary

stance

from

mid-1970

to the

end

of 1972

(see

Figure

3).

Interestingly,

the

Boschen-

Mills

index,

which is

based on

narrative

evidence,

is

mostly

neutral

during

this

period

with

the

exception

of

1970-1971.

The reason

is

that

the

Boschen-Mills

index is based

on

policy

pronouncements

as

opposed

to

policy

actions.

Quite

simply,

the Fed's

pronouncements

in

this

period

were

uninformative

at

best and

probably

misleading.

Both

the

Boschen-Mills index and

the

Bernanke-Mihov

index

show

a

sharp

tightening

of

monetary

policy

in

early

1973.

The

Boschen-Mills

indicator,

on

a

scale from

+2

(very

expansionary)

to

-2

(very

tight),

moves

from neutral at

the

end of 1972

to

-1

for

the first

three

months of

1973. It

then

spends

the

next 6

months at

-2,

followed

by

two

months at

-1,

ending

the

year

in

neutral.

Further,

the

Bernanke-Mihov

index

shows a

sharp

and

prolonged

contraction

in

monetary

policy

by

early

1973

150

*

BARSKY

& KILIAN

Figure

3

INDICATOR OF OVERALL

MONETARY POLICY

STANCE,

JANUARY

1966

TO

DECEMBER 1988

0.

1968

1970 1972

1974 1976 1978

Source:

Courtesy

of B. Bernanke and

I.

Mihov.

(see

Figure

3).6

As noted

by

Boschen and Mills

(1995),

this contraction

was

an

explicit

response

to

rising

inflation. It

occurred

long

before the distur-

bances

in

the oil market

in

late 1973 and

provides

an

alternative

explana-

tion

of

the recession

in

early

1974.7 The

contractionary

response

of the

Fed

in 1973 to

the

inflationary pressures

set

in

motion

by

earlier Fed

policy

is

a

key

element

of

our

monetary explanation

of

stagflation.8

Note

that the

observed increase

in

inflation

in

1973 is understated

as a result of

price

controls,

and

the observed

increase

in

1974 is overstated

due

to

the

lifting

of the

price

controls

(see

Blinder,

1979).

6. The

downturn in the

Bernanke-Mihov index in

1973 reflects a

sharp

rise

in

the Federal

Funds rate.

Interestingly,

as

Figure

5d

shows,

although

the real interest

rate

rose,

it

remained

negative throughout

1974.

Thus,

the

contractionary

effect of the

monetary

tightening

must have worked

partly through

other channels such as

the

effect of

high

nominal

interest rates on

housing

starts in

the

presence

of

disintermediation

due

to

interest-rate

ceilings.

7.

This

interpretation

is

consistent

with

Bernanke,

Gertler,

and

Watson's

(1997)

conclusion

that

the Fed in 1973 was

responding

to the

inflationary

signal

in

non-oil

commodity

prices,

not to the oil

price

increase as is

commonly

believed.

8.

There

is

no Romer date for

1973,

despite

the clear evidence of a

shift

in

policy

toward a

contractionary

stance.

Do We

Really

Know

that

Oil Caused the Great

Stagflation?

?

151

As the

U.S.

economy

slid

into recession

in

1974,

the Fed

again

re-

versed course to

ward off

an

even

deeper

recession.

Indicators show

a

renewed

monetary expansion

that lasted

into

the late 1970s. The

Ber-

nanke-Mihov index indicates

that

monetary policy

was

strongly

expan-

sionary

from late 1974

into 1977

(see

Figure

3).

This

expansion

was

not

initially

reflected

in

high

inflation,

in line with our earlier discussion

of

sluggish

inflation.

Boschen and Mills record

a

similar,

if

somewhat

briefer,

expansion.

Around

1978,

the

monetary

stance turned

slightly

contractionary, becoming strongly

contractionary

in late 1979 and

early

1980 under Paul

Volcker,

as inflation continues

to worsen. Once

again,

the

monetary policy

stance

provides

an alternative

explanation

for the

genesis

of

stagflation.

4.2

WORLDWIDE CHANGES

IN

LIQUIDITY

The

changes

in

monetary policy

indicators

in the 1970s

in

the

United

States,

and indeed

in

many

other OECD

countries,

were

accompanied

by unusually large swings

in

global liquidity.

One indicator of

global

liquidity

is world

money growth.

We focus on world

(rather

than

simply

U.S.)

monetary growth,

both because

the

prices

of

oil

and

non-oil com-

modities are

substantially

determined

in

world

markets,

and

because-

despite

its

origins

in

the U.S.-the

monetary expansion

in

the

early

1970s was

amplified

by

the

workings

of the international

monetary sys-

tem,

as

foreign

central banks

attempted

to stabilize

exchange

rates

in

the

1968-1973

period.

The

counterpart

of the

foreign-exchange

intervention

in

support

of the dollar was the

paid

creation of domestic credit

in

all of

the

large

economies

(see

McKinnon,

1982;

Bruno and

Sachs, 1985;

Genberg

and

Swoboda,

1993).

Figure

4a and b

show

a

suitably updated

data set for

GNP-weighted

world

money growth

and

inflation,

as defined

by

McKinnon

(1982).

There is evidence

of

a

sharp

increase

in

money growth

in

1971-1972 and

in

1977-1978

preceding

the two

primary stagflationary episodes

in

Table

1.

The increase

in

world

money

growth

is followed

by

a substantial

rise

in

world

price

inflation

in

1973-1974 and in

1979-1980

(see

Figure

4b).

The

data also

show

a

third

major

increase

in

world

money-supply

growth

in

1985-1986.

This does

not

pose

a

problem

for

the

monetary

explanation

of

stagflation,

because

1985-1986 is

fundamentally

different

from

1973-1974 and

1979-1980.

The coincidence of

substantial

money

growth

and low

world

inflation

constitutes

a

partial

rebuilding

of real

balances

following

the restoration

of the

commitment to

low

inflation.9

9.

This is

precisely

the standard

interpretation

of the

patterns

of

inflation and

money

growth

that

have

been

documented for the

period

following

the

monetary

reform that

ended the

German

hyperinflation

(see

Barro, 1987,

p.

206,

Table

8.1).

152

-

BARSKY

& KILIAN

Figure

4

MEASURES OF WORLD

LIQUIDITY

(a)

World

Money

Growth: Ten

Industrial

Countries

(b)

World Price Inflation: Ten Industrial Countries

15

20

15

...I

10

l

U)

0

-5

1960

1965

197

1975

1980

1985

1960 1965 1970 1975 1980 19

(c)

Growth

of

World

Real Balances:

Ten

Industrial Countries

15

10

5

20

-10

-15-

1960

1965 1970

1975

1980

1985

Source:

Inflation

and

money

are

GNP-weighted

growth

rates

per

annum

as

defined

by

McKinnon

(1982,

pp.

322),

based

on

IFS

data

for

1960.1-1989.4.

We

now

turn

to

the

United

States,

where the

monetary expansions

of

the

1970s

originated.

Figure

5

shows

that

U.S.

liquidity

followed a

pat-

tern

similar

to

that

of other

industrial countries.

Figure

5a

shows

two

large

spikes

in

money growth

in

1971-1972

and in

1975-1977

that

pre-

ceded

two

episodes

of

unusually

high

inflation

in

the

GDP

deflator

in

1974 and

in

1980

(see

Figure

5b)

and

that

coincided

with

two

episodes

of

significantly

negative

growth

in

real

money

balances

in

1973-1974

and

1978-1980

(see

Figure

5c).

Figure

5c

also

shows

evidence

of

a

rebuilding

of

real

balances

(and

possibly

of the

financial

deregulation)

after

1980.

Additional

evidence

of

excess

liquidity

in

the

1970s is

provided

by

the

behavior of

the U.S.

real

interest

rate.

Figure

5d shows

that 1972-1976

and

1976-1980

were

periods

of

abnormally

low

real interest

rates,

followed

by

unusually high

real interest

rates

in

1981-1986.

This

pattern

is

consistent

with the

view that

the excess

money

growth

in

the

early

and

mid-1970s

depressed

ex

ante

real interest

rates

via a

liquidity

effect

and

further

depressed

ex

post

interest

rates

by

causing

unanticipated

inflation.

The

evidence

in

Figure

5d

also is consistent

with

the

view

that the Fed

in

the

1970s followed

an interest-rate

rule

that was

more tolerant

of

inflation

than would

have been

consistent

with a

Taylor

rule

as estimated

over

the

Do We

Really

Know

that Oil Caused

the Great

Stagflation?

*

153

Figure

5 MEASURES

OF

U.S.

LIQUIDITY

(a)

U.S.

Money

Growth

(b)

U.S.

Deflator Inflation

10

03

ao

cL

8

6

4

2

1

a)

0

a)

0-

OE

n

. .

1960 1965

1970

(c)

Growth

of U.S.

Real

Balances

.. ..

10

5

0

-5

1960 1965 1970 1975 1980 1985

1975 1980

1985

(d)

U.S. Real Interest Rate

I I I I

-

5-

0

^vH

^

.A.

i

1960 1965 1970

1975 1980 1985

Source:

(a)

Based on

DRI

series FM2.

(b)

Based on DRI series GDPD.

(c)

Based on DRI

series

FM2 and

PRXHS.

(d)

Based on DRI series FYGM3 and PRXHS.

Volcker-Greenspan period

(see

Clarida, Gall,

and

Gertler,

2000).

Finally,

the

timing

in

Figure

5d contradicts the view that oil

shocks were

responsi-

ble

for the low ex

post

real interest rates. Real

interest rates were

negative

during

1973,

after the evidence of

excess

money growth,

but

well before

the two

major

oil

price

increases.

In

fact,

the 1973-1974 and

1979-1980 oil

price

increases were followed

by

a

rise

in

ex

post

real interest

rates.

4.3

MOVEMENTS IN

OTHER

INDUSTRIAL COMMODITY

PRICES

An

important

additional

piece

of evidence that

has received

insufficient

attention in

recent

research is

the

sharp

and

across-the-board

increase

in

industrial

commodity prices

that

preceded

the

increase

in

oil

prices

in

1973-1974

(see

Figure

6).

These

increases occurred

as

early

as

1972,

well

before

the

October

War,

and

are too

broad-based

to

reflect

supply

shocks

in

individual

markets.

They

are,

however,

consistent

with

a

picture

of

increased

demand

driven

by

the

sharp

increase

in

global

liquidity

docu-

mented in

Figure

3.

There is

significant

evidence that

poor

harvests

caused food

prices

to

soar

in

the

early

1970s

(see

Blinder,

1979).

Our data

set

deliberately

rc

a)

03

c)

0-

,

I

LA

-

154

*

BARSKY

&

KILIAN

Figure

6

NOMINAL PRICE INDEXES

FOR CRUDE OIL AND FOR

INDUSTRIAL

COMMODITIES, JANUARY

1948 TO

JULY

2000

-

1

-

I I I

I

1950

1955

1960 1965 1970

1975

1980

1985

1990 1995

2000

Source: All

data are

logged

and de-meaned.

The

commodity

price

index

excludes oil

and

food. The index

shown is an index

for industrial

commodity

prices

(DRI

code:

PSCMAT).

Virtually

identical

plots

are

obtained

using

an

index for sensitive materials

(DRI

code:

PSM99Q).

The oil

price

series is defined as

in

Figure

1.

excludes

food-related commodities.

Instead,

we focus on

industrial

raw

materials.

Commodities such as

lumber,

scrap

metal,

and

pulp

and

pa-

per,

for

which

there

is no

evidence

of

supply

shocks,

recorded

rapid

price

increases in the

early

1970s

(see

National

Commission on

Supplies

and

Shortages,

1976).

For

example,

the

price

of

scrap

metal

nearly

dou-

bled

between October

1972

and

October

1973,

and

continued to rise until

early

1974,

to

nearly

four times its initial level. The

price

of lumber

almost

doubled between

1971 and

1974,

as

did

the

price

of wood

pulp.

These

commodity price

data

paint

a

picture

of

rapidly rising

demand for

all

commodities

in

the

early

1970s.

It

is

interesting

to

note

that a

similar

increase

did

not

occur

in

oil

prices

until

late 1973.

Similarly,

the

1979 increase

in

oil

prices

was

preceded by

a

boom

in

other

commodity prices,

consistent with

the evidence of mone-

tary

expansion, although

the

commodity price

increase is of lesser

magni-

tude.

In

fact,

a

striking empirical regularity

of the data in

Figure

6 is that

Do We

Really

Know that Oil Caused

the Great

Stagflation?

*

155

increases

in

other

industrial

commodity prices

tended to

precede

in-

creases

in

oil

prices

over the 1972-1985 OPEC

period

(and

similarly

for

decreases).

This fact is

evident for

example

in

1972,

1978, 1980,

1983,

and

1984.

A

natural

question

is

how

the

monetary

explanation

of

stagflation

proposed

here

can be reconciled

with

the

delayed response

of oil

prices

relative

to

other

industrial commodities.

The

explanation

appears

to

be

that,

unlike other

commodity

transactions,

most

crude-oil

purchases

until the

early

1980s did

not

take

place

in

spot

markets,

but at

long-term

contractual

prices.

The

sluggish

adjustment

of these contractual

prices

in

response

to demand conditions

in

commodity

markets

tended

to

delay

the

response

of

the

oil

price

relative to

the

price

of more

freely

traded

commodities,

until

the

spot

market

largely

replaced

traditional oil

con-

tracts

in

the

early

1980s.

4.4

BUSINESS-CYCLE

INDICATORS

Finally,

the

monetary

explanation

is consistent

with

evidence

of an

im-

pending

recession

long

before

the first oil

price

shock in October

1973-

January

1974,

but

shortly

after the

monetary tightening

of

early

1973.

Both

the

expected

conditions

component

of

the index of consumer confidence

and the

index

of

leading

indicators

peaked

in

January

1973,

when mone-

tary

policy

switched to

a

contractionary

stance

in

response

to

rising

infla-

tion. Consumer durables started

falling

relative to trend

in

early

1973,

as

would be

expected

in

response

to

a

monetary tightening.

Similar

declines

can be observed

in

the numbers of

housing

starts and

motor-vehicle

pur-

chases.

Figure

7

suggests

that

both consumers

and

economic forecasters

were

expecting

a recession

many

months before

the

October

1973 war and

the

subsequent

oil

embargo,

and that this

expectation

was not driven

by

concerns over OPEC. The

decline

in

the

index of

leading

indicators contin-

ued

throughout

1974.

Although

we cannot tell to

what

extent

the

fall

in

the index of

leading

economic indicators after

September

1973

can be

attributed to oil as

opposed

to

money,

a full

two-thirds of the fall in

consumer

confidence

in

1973-1974

was

completed

prior

to the

oil

date.

5.

What

Explains

the Initial

Monetary

Expansion

of

the 1970s?

The

U.S.

economy

moved from an

extended

period

of

low

and

stable

inflation at the

beginning

of

the

1960s

to

one

of

high

and

variable

infla-

tion

by

the

end

of

the

decade.

The

underlying

cause of the

shift towards

higher

inflation

was the

gradual

reduction in the

United

States's commit-

ment to the twin

goals

of low and

stable

inflation

and

the

avoidance

of

"excessive"

balance-of-payments

deficits.

In

the late

1960s,

the central

156

*

BARSKY &

KILIAN

Figure

7

BUSINESS-CYCLE INDICATORS WITH OPEC

I

OIL DATES:

(a)

EXPECTED

CONDITIONS

COMPONENT OF

CONSUMER

CONFIDENCE;

(b)

REAL

DURABLES

CONSUMPTION

(PERCENT

DEVIATION FROM

HP-TREND); (c)

INDEX OF

LEADING

ECONOMIC INDICATORS

(a)

1975 1975.5 1976

(b)

Do We

Really

Know that Oil Caused the

Great

Stagflation?

?

157

Figure

7

CONTINUED

8 6

I

i

I i I 1

I

84

-

82-

-

80-

78-

76

74-

72-

1971.5

1972

1972.5 1973 1973.5 1974 1974.5 1975 1975.5 1976

(c)

Sources:

(a)

Survey

of

Consumers,

University

of

Michigan;

(b), (c)

based on DRI data.

bank's commitment to

these traditional

goals

was

increasingly

diluted

by

the

additional

goal

of

maintaining

high employment.10

The dilution of

the commitment

to

controlling

inflation and

balance-of-payments

defi-

cits was behind both the

weakening

(and

ultimately

the

destruction)

of

the Bretton

Woods

system

and

the initiation of

expectations

of

high

and

persistent

inflation in

the

late

1960s. The rise in

inflationary expectations

in turn

triggered

an

inflation

trap by raising

the

cost

of

subsequent

disinflations

(also

see Christiano and

Gust,

2000).11

These

inflationary

pressures

were reinforced

by

two serious errors of economic

analysis

on

10.

This

change

in

focus

can

be traced

ultimately

to the Great

Depression

and

the

percep-

tion that

tight

monetary policy

had been

responsible

for

excessively

high unemploy-

ment

during

the Great

Depression.

The

rise

in

social

and

political

commitment to

full

employment

was

furthered

by

an

intellectual belief

in

the more or less

permanent

exploitability

of the

Phillips

curve

(see

Samuelson

and

Solow,

1960).

The refusal to rein

in social

spending

or to allow a

sharp

rise in

interest

rates,

as the Vietnam

war

ex-

panded

in

the late

1960s,

reflected the

change

in

priorities.

11. What

makes the

expectations-trap hypothesis plausible

is evidence that

by

1971 the Fed

indeed

perceived

a shift in the

public's expectations

of inflation. As Christiano

and

Gust

(2000)

note,

Arthur

Burns

was

concerned

about

expectations

of inflation as

early

as December 1970.

By

1971,

he

perceived

a shift in

inflationary expectation

due to the

steady

rise

of

consumer-price

inflation since

1965,

well before the

commodity supply

shocks,

the

oil

shocks,

and the

monetary expansion

of the

early

1970s

(see

Burns,

1978,

pp.

118,

126).

158

*

BARSKY & KILIAN

the

part

of the

Federal

Reserve:

first,

a

miscalculation of full

employment

in

the wake of the

productivity

slowdown and of structural

changes

in

the

labor

market

(see

Orphanides,

2000;

Orphanides

et

al.,

1999);12

and,

second,

an

increased

tendency

to attribute

inflation to

"special

factors"

rather than the

underlying monetary

environment.13

A

third

element

was the

exploitation

of

the

newly

unconstrained

policy

environment in

the service of electoral

politics.14

A

number

of

authors

(see

McKinnon, 1982;

DeLong,

1997;

Mundell,

2000)

have

suggested

that the

collapse

of the

gold exchange

standard

associated

with

Bretton

Woods

played

a

key

causal

role

in

the

creation of

the

inflationary monetary

environment of the

1970s.15

Although

it is

widely accepted

that

the eventual

collapse

of the Bretton

Woods

system

was

inevitable due to fundamental

structural flaws

(see

the

papers

in

Bordo

and

Eichengreen,

1993),

the

timing

of its demise was influenced

by

the same factors

that also

launched the

initial

wave

of

inflation

in

the

mid-1960s to

1970.

The

collapse

was

triggered

by

an

excess

supply

of

U.S. dollars

resulting

both from the

expansion

of the U.S.

monetary

base

and

a

reduction

of the demand for dollars abroad driven

by

the

expecta-

12.

Orphanides

(2000)

documents

that

the measurements of real

output

available to the

Fed

following

both the 1970 and

1974

recessions were

substantially

lower

than

the

output

data

now available.

At

the same

time,

official estimates

of

potential

real

output

were

in

retrospect

far

too

optimistic, resulting

in

excessively high

estimates

of the

output gap,

defined

as the shortfall of actual

output

relative to

potential.

Drawing

on

evidence from

simulated

real-time

Taylor

rules and on the Fed minutes

and

the recollec-

tions of the

policymakers

involved,

Orphanides

concludes

that

the increase

in

the

natural rate

of

unemployment

and the

productivity

slowdown

in

the

late

1960s and

1970s were

two

major

factors

in

explaining

the

inflationary

outcomes

of

the

period.

13.

For

example,

Hetzel

(1998)

makes

the

case

that then chairman Arthur Burns adhered

to

a

special-factors

theory

of inflation

which attributed

increases

in

inflation

to a

variety

of

special

circumstances

ranging

from unions and

large corporations

to

government

defi-

cits and

finally

food

and

oil

price

increases.

Hetzel

argues

that Bums

systematically

discounted

any

direct effects from increases

in the

money

supply

on inflation

and did

not

appear

to

be

overly

concerned

about the extent of the

monetary expansion

in the

early

1970s.

For a similar

view

see Christiano

and Gust

(2000).

14.

For

example,

DeLong

(1997)

stresses

that the inflation of the

early

1970s

was fueled in

addition

by

Arthur

Bums's efforts

to

facilitate

Nixon's

reelection

through expansionary

monetary policy.

Christiano

and Gust's

(2000)

narrative

evidence that

Burns was

not

intimidated

by

Nixon

does not contradict this

interpretation,

because

Burns's conserva-

tive economic

views were

closer to Nixon's than

to

those

of his

Democratic

opponent.

15.

The

temporal

coincidence

is

indeed

an

impressive

one. The

breakdown

of

the

Bretton

Woods

system

was foreshadowed

by

the introduction

in 1968 of

a

two-tiered

system

of

convertibility

with

significantly higher

prices

for

private

than for

official

transactions,

in

response

to the

declining private-sector

confidence

in

the

dollar

peg.

It became

official when

President Nixon

announced

the

"closing

of

the

gold

window"-ending

the

convertibility

of dollars into

gold

in

August

1971.

The relaxation of the convertibil-

ity

constraint coincided

with a dramatic

increase

in

U.S.

monetary growth

(see

Figure

3a)

and

a

period

of

expansionary monetary policy

between mid-1970

and late

1972,

as

indicated

by

the Bernanke-Mihov

index.

Do We

Really

Know

that

Oil

Caused

the Great

Stagflation?

*

159

tion of

an

incipient

depreciation

of the dollar

(see

McKinnon,

1982;

Bruno

and

Sachs, 1985;

Genberg

and

Swoboda,

1993).

In

this

sense,

the

breakdown

of the Bretton Woods

system

was

endogenous.

At

the

same

time,

awareness

of

the loss

of

prestige

that

would

accom-

pany

suspension

of

convertibility

continued

until the

end

to serve as a

partial

commitment device

that

contributed

significant

restraint

against

higher

inflation

(see

Bordo

and

Kydland,

1996).

By completely

removing

this

constraint,

the

1971

closing

of the

gold

window

permitted

a

second

round of

monetary expansion starting

from

an

already high

base.

In

this

sense,

the

breakdown

of the Bretton Woods

system

may

also be

consid-

ered one of the causes of

the

monetary expansion.

As stressed

by

Kydland

and

Prescott

(1977)

and Barro

and

Gordon

(1983),

the

incentive

of the central bank to stimulate

employment

in

the short

run tends

to

produce

an

excessively high

rate of inflation

in

the

absence

of

a

suitable

commitment mechanism. Not

until the

development

of new

commit-

ment

devices

in

the form of a

lexicographic

intellectual

commitment

to

price stability

and

the cult of the conservative central banker at the

beginning

of the 1980s

(see

Rogoff,

1985)

was the

prevailing

inflation

reduced to

the levels of the

early

1960s. The

reason

that the

1970s are

different from the

preceding

and the

following

decade

thus

is the

ab-

sence

of

effective constraints on

monetary policy.

As the

global

monetary

system

underwent dramatic

changes

in

the

early

1970s,

both

central

bankers

and

private

agents slowly

had to

adapt

to the new rules of

the

game.

The

monetary

expansion

was

not immedi-

ately

understood

by

market

participants

and

required

a

process

of learn-

ing

that

is reflected

in

the

sluggish

adjustment

of

inflation

in

the model

of Section 3.

Furthermore,

the

Fed

itself

was

operating

in a

new mone-

tary

environment without

the traditional

constraints

and

needed to learn

about

the

consequences

of its own

actions. There was

a

widespread

sense

that

"the rules of

economics are

not

working

in

quite

the

way they

used

to"

(see

Burns,

1978,

p.

118).

This

element of

trial

and

error is

important

in

understanding

the

go-and-stop

nature of

monetary policy

in

this

period

and

helps

to

explain why

the

generally

inflationary

stance

of

monetary

policy

was

punctuated

by

occasional

sharp

contractions.

It

also

helps

to answer the

question why

the

Fed did

not learn

from its

mistakes after the first

episode

of

go-and-stop

monetary

policy

ended

in

1974.

The data

for

U.S.

monetary

growth

in

Figure

5a

show

a

renewed

expansion

that

coincided with

a

period

from

late

1974

until

1977,

in

which

policy

indicators

signal

a

second

"go" phase

for

monetary

policy.

Part of

the

explanation

may

be

that,

at

the

time,

the

Fed

attributed at

least

part

of the

observed

stagflation

to oil

supply

shocks and

other

special

factors.

More

importantly,

the Fed

lacked

a

political

mandate

for

160

*

BARSKY &

KILIAN

serious reform. The lack of

commitment to

maintaining

low inflation

could

only

be overcome

by

the

experience

of

double-digit

inflation

in

the

late

1970s.16

6.

How

Convincing

is the

Aggregate-Supply-Shock

Explanation of

Stagflation?

The view that the historical

pattern

of

stagflation

can be accounted for

by

the effects of

money

does

not

preclude

the

possibility

that oil shocks

played

a

major

role

in

generating

the

stagflation

either

directly

or

indi-

rectly

by inducing

a

policy response.

In

this

section,

we will

demonstrate

that the

supply-shock explanation

of

stagflation

is

less

convincing

than

commonly thought.

6.1 IS

THE

TEXTBOOK

ANALYSIS OF AGGREGATE SUPPLY

SHOCKS

CONVINCING?

GROSS

VS.

VALUE-ADDED CONCEPTS

OF OUTPUT AND PRICE

The

textbook view is

that oil

price

shocks

are

of

necessity inflationary.

The

only

question

is

the

magnitude

of the

inflationary

effect. As we

will

show,

however,

this

claim

is

unambiguously

true

only

for the

price

of

gross

output,

not for

the

price

of

value

added.

The

following

coun-

terexample

demonstrates

that

oil

price

shocks

may

in

fact

have a defla-

tionary

effect

on the

price

of value

added,

even as

they

raise the

price

of

gross

output.

Suppose

gross output

Q

is

given

by

the

production

function

Y

=

Q[V(K,

L,

x),

O],

where

x

denotes

a

technology

disturbance,

O

denotes the

quan-

tity

of

a

foreign

commodity import

("oil"),

and

V(K,

L,

x)

is domestic

value

added. As

is

standard,

we assume

separability

between

O

and the other

factors

in

order

to ensure

the existence

of a value-added

production

func-

tion. As

is

immediately

clear,

a

decline

in

O,

under

separability,

is not

a

shock

to the

production

function for value

added-the

ability

to

produce

domestic

output

is

unchanged.

It follows

that oil

shocks

cannot

play

the

role of

a

technology

shock

in a

standard

real-business-cycle

model

(i.e.,

they

do not alter

value

added,

holding

constant

capital

and

labor

input),

although

they

do

lower the

quantity

of

gross output.

Following

Rotemberg

and

Woodford

(1996),

we consider

an

economy

in

which

symmetric

firms

produce

final

output

using

the

gross

output

production

function

Yt

=

Q(Vt(Lt),Ot),

(2)

16.

Sargent

(1998)

provides

a

detailed account

of

competing

explanations

of the transition

back to

a low-inflation

regime.

Do

We

Really

Know that

Oil

Caused the

Great

Stagflation?

*

161

where

Ot

is

the

quantity

of

foreign

oil

used

in

production,

Q

is

homoge-

neous of

degree

one

in

its

arguments,

and

Vt

is

a

function of labor

hours

and

capital.

The

capital

stock

is assumed to

be

fixed,

ensuring

concavity

of

Vt. Let

gross

output

be the

numeraire.

Vt,

the

value added

associated

with

capital

and

labor,

should

be

thought

of

as real

GDP.

Nominal

GDP

is

given by

PtYt

-

P?

Ot,

where

P?

is the

price

of

imported

oil.

Further

postulate

that

the demand

for

money

balances is

proportional

to nominal

gross

output:

M

=

kPY,

(3)

where

Pt

is the

price

of

gross

output.

Thus,

nominal

gross

output

is

determined

by

the

money

stock alone.

Now

suppose

that

labor

is

supplied

inelastically.

Further

suppose

that

all

markets

are

perfectly

competitive.

Logarithmically

differentiating

(2)

and

(3)

with

respect

to

P?,

we obtain

AY=-

E

vAPo,

(4)

1

-

so

APt

=

1

APO

(5)

1

-

So

where

A

denotes

percent

changes,

so

is the

cost

share

of oil

in

gross

output,

and

o,

v

is

the

elasticity

of

substitution

between

value

added and

oil.

This

means that an

increase

in

the

price

of

imported

oil will

tend

to

lower

the

quantity

of

gross

output

and

raise the

price

of

gross

output.

the

deflator

for

value

added,

defined as

the

ratio

of

nominal

to real

value

added:

PV

=

PY-POt

t

PtYt(l-So)

t

(6)

Vt(Lt)

Again

consider an

increase

in

the

price

of

imported

oil.

Clearly,

under

our

assumptions

the

denominator of

(6)

does

not

vary

with

the

price

of

oil.

The

numerator, however,

will

fall,

since

by

(3)

nominal

gross

output

is

determined

solely by

the

money

stock,

and

the

cost

share

of

imported

oil in

gross

output

is

expected

to

rise

in

response

to an

oil

price

increase

(see

Gordon,

1984;

Rotemberg

and

Woodford,

1996).

Thus,

the oil

price

shock

lowers

the

price

of

value

added,

even

as it

raises

the

price

of

gross

output.

162

*

BARSKY & KILIAN

This

stylized

example

illustrates

that

the

aggregate-supply-shock

analysis

of oil

price

changes

is

questionable.

Whereas

aggregate-supply

shocks

in

the textbook

model are

stagflationary

for

value

added,

oil

price

increases

may

actually

be

deflationary.

In

this

sense,

in

our

example

they

are

closer

in

spirit

to

aggregate

demand

shocks than

to

aggregate supply

shocks.17 How

realistic is this

counterexample?

Clearly,

to

overturn our

benchmark result

would

require

a

sufficiently

sharp

fall in

real

value

added

in

response

to

an

oil

price

shock,

without a

commensurate

drop

in

the

money

stock. We now

discuss

several

mechanisms

by

which oil

price

shocks

may

in

principle generate

a fall in

the

quantity

of

value

added.

Since oil

shocks

are

not

productivity

shocks,

the

key

to

establishing

that oil

price

shocks affect value

added

then must be

showing

that

labor

and

capital inputs

change

in

response

to an oil

price

shock.18 One

model

that

establishes

such

a

link is the

sectoral-shifts

model

of

Hamilton

(1988).

A

related channel has

been

discussed

by

Bernanke

(1983),

who

shows

in

a

partial-equilibrium

model that oil

price

shocks

will

tend to

lower

value

added,

because firms

will

postpone

investment

as

they

at-

tempt

to

find

out

whether the

increase

in

the

price

of

oil is

transitory

or

permanent.

Even

if

we

accept

the view that

an

oil

price

shock

lowers real value

added, however,

there is no

presumption

that

this shock

will

be

stagfla-

tionary.

First,

consider the case of

a

fixed

money

supply.

It

is not

enough

to show that value added falls

in

response

to an oil

price

shock.

For

the

price

of value added

actually

to rise when the

money supply

is

fixed,

value added must fall

by

more than

the

numerator

in

(6).

More

generally,

the

money supply

will

not be fixed.

In

that

case,

the direction of the

change

in

the

price

deflator also

depends

on

the Fed's

reaction

to the

fall

in

value added. The

optimal

Fed behavior would be

to contract

the

money supply

in

response

to the fall

in

value added

(see

King

and

Goodfriend,

1997).

We have

already

shown

that indeed the Fed was

conducting contractionary monetary policy

at

the

time of the oil

price

17. An

additional

factor that reinforces

the

aggregate-demand-shock interpretation

is

the

transfer

of

purchasing

power

from the United States

to

OPEC

(see

Bruno

and

Sachs,

1985).

18.

Under

imperfect

competition,

as

noted

Rotemberg

and Woodford

(1996),

an

oil

price

shock does result

in

a rise

in

the

supply

price

for

all

levels of

value added. This increase

occurs

because

firms

apply

the

markup

to

all

cost

components, including

imported

oil,

not

just

to

capital

and

labor. The

magnitude

of this

effect,

however,

is

likely

to be small

for reasonable

markup

ratios,

unless we allow

in

addition

for substantial

changes

in

the

markup

over time.

The latter

possibility

is discussed

by Rotemberg

and Woodford

(1996),

who show

that

a

model

involving implicit

collusion between

oligopolists

in

the

goods

market can

yield output responses

to

an

oil

price

shock

that are

quantitatively

important.

Do We

Really

Know

that

Oil Caused

the

Great

Stagflation?

*

163

shocks. Whether this

monetary

contraction

would have been

enough

to

stabilize the

price

level,

as value

added

fell,

is an

empirical question.

Either

way, monetary policy plays

a

key

role

in

determining

the effect

of

oil

price

shocks

on inflation.

This discussion

shows

that

the

implications

of

an

oil

price

shock

are

unambiguous

only

for

the

price

of

gross output

measures

such as

the

consumer

price

index

(CPI).

Although

one could construct other

exam-

ples,

in

which

oil

price

shocks are

inflationary

for the

price

of

value

added

(measured

by

the GDP

deflator),

there

is no

presumption

that in

general they

are.

The direction and

strength

of

the

effect of oil

price

shocks

on

the GDP

deflator

is

an

empirical question.

6.2

DO OIL

PRICE

SHOCKS

MOVE

THE

GDP

DEFLATOR?

The

preceding

discussion

stressed

the

important

distinction between

infla-

tion

in

prices

of

gross

output

(such

as the

CPI)

and of

value

added

(such

as

the GDP

deflator).

In

this

section,

we

provide

some

empirical

evidence

about the

timing

and

relative

magnitude

of the

changes

in

the

GDP defla-

tor

and

the CPI

inflation rates

during

major

oil

price changes

that sheds

light

on

the relative

contributions of oil and

money

to the

inflation

in

the

GDP

deflator observed

in

the

1970s.

Figure

8

shows the annualized infla-

tion rates

for

gross

output prices

(as

measured

by

the

CPI)

and

the

price

of

value

added

(as

measured

by

the GDP

deflator)

for

the

United States

in

the

period

1960.1-2000.2.19 We

use the

PRXHS

index

of

consumer

prices,

which

excludes

housing

and

shelter.

Despite

the

obvious

differences

in

the content and

construction of

these two

indices,

there

is

strong

comovement

in

the

long

run.

For our

purposes,

it

will be

of

interest to

focus on

five

major

episodes:

the two

major

oil

prices

increases of 1973-

1974 and

1979-1980,

the

major drop

in

oil

prices

in

early

1986,

the invasion

of Kuwait

in

1990-1991,

and

the recent oil

price

volatility

since

1997.

Our

first

observation is that

Figure

8

shows an

unusual

discrepancy

between

the

deflator and CPI

inflation

rates

during

each

of the five

episodes

of

interest.

CPI

inflation rose

sharply

relative to deflator infla-

tion

between 1972

and 1974

and

again

in

1979 and

early

1980.

This result

is not

surprising,

as

these

periods

were

characterized

by major

fluctua-

tions

in

world

commodity

markets.

To

the

extent that

prices

of

imported

19. Our

theoretical

counterexample

maintained

the

implicit

assumption

that

no oil is

pro-

duced

domestically.

This is not

an

issue for

most OECD

countries

in

the

1970s

with

the

exception

of

the

United States.

There

are reasons to doubt

the

quantitative

importance

of this

channel,

however,

even for

the United

States,

given

the small

share of

domestic

oil

in

U.S.

GDP.

It

may

be shown

that the

inflation rate

for

the non-oil

component

of

U.S. GDP will

be

lower than

the

inflation rate

for the total

GDP

deflator,

but that the

overall

results are

qualitatively

similar under

realistic

assumptions.

164

*

BARSKY &

KILIAN

Figure

8

QUARTERLY

U.S.

INFLATION RATES FOR

1960.1-2000.2

18-

..

-CPI1

-

Deflator

14-

12-

10-

8

6

4

2

0

-2

-4

1965

1970I

I I I

8

195

2000

1970 1975

1980 1985

1990 1995

2000

Source: All data are

growth

rates

per

annum. All data

are taken from

the

DRI

database. We use

PRXHS

(consumer

prices excluding

shelter)

as the

CPI

measure,

and GDPD as the

implicit

GDP deflator.

oil and other

imported

commodities

enter the CPI but not

the

deflator,

our

earlier discussion

suggests

that we

should

expect

to

see

a

wedge

between

inflation

in the

CPI and

in

the

deflator.

Moreover,

it

is

well

known that

especially

price-sensitive

items such as

food

(whether

im-

ported

or

not)

have

higher weights

in

the

CPI than in

the

deflator,

adding

to

the

discrepancy. Similarly,

the

1986 and

1990-1991

episodes

are characterized

by

a

differential

response

of CPI

and

deflator inflation

rates.

The

same

differential

response

occurs

after

1997,

as

oil

prices

first

plummet

and

then

experience

a

dramatic reversal in

1999

and

2000.

Our second

observation is that

during

the 1970s

increases

in

CPI

infla-

tion

rates

tended

to

precede

increases

in the

inflation rate of

the

deflator.

Although

CPI

inflation reached

double-digit

rates

in

early

1974,

the bulk

of the

inflation

in

the deflator

only

occurred from

mid-1974 to

1975.

Similarly,

although

CPI

inflation

rates

rose

sharply

in

1979-1980,

the

bulk of

the increase in the

inflation

in

the deflator

occurred

only

in

mid-

16

-

Do We

Really

Know that Oil Caused the Great

Stagflation?

*

165

1980-1981.20

One

possible explanation

for

this

difference

in

timing

is

that

value added fell for

the

reasons described

by

Hamilton

(1988),

and

mone-

tary

policy

did not contract

enough

to

prevent

an

increase

in

the

price

level.

An

alternative

explanation

is

that

the

delayed

inflation

was

caused

by

the

earlier

monetary

expansion.

The latter

explanation

seems

more

plausible,

given

that

of

the five oil

episodes

in

our

sample period only

the

1973-1974 and 1979-1980

episodes

are

associated

with

large changes

in

the deflator inflation

rate-but

none

of

the other

major

oil

price

changes.

Of

particular

interest

is the

1986 fall in the oil

price following

the

collapse

of

OPEC. The fact that

the

sharp

deflation

in the CPI

in

1986

was

accompanied by only

a

minor reduction

in

deflator

inflation casts

doubt

on the view that

oil

was

responsible

for

deflator inflation

in

earlier

peri-

ods.

Similarly,

during

1990-1991 deflator inflation

changed

little

by

his-

torical

standards.

Further evidence

against

the

oil-supply-shock

view of

stagflation

is

provided

by

the events of 1997-2000.

During

this

period

oil

prices

first fell

sharply

to

an

all-time low and then

rose

sharply

to

heights

not seen since

1979-1980. As

expected,

these oil

prices

swings

are

re-

flected in

considerable

swings

in

CPI inflation rates

in

Figure

8,

but

they

have

little,

if

any,

effect

on deflator inflation.

Figure

8

illustrates that the

high

correlation of oil

price

shocks

and

subsequent

increases

in

deflator inflation

that

we observe

in

the 1970s

breaks down

in

other

periods.

We

interpret

this

evidence as

supportive

of the view that

this

relationship

is

largely

coincidental. The

monetary

explanation

of

stagflation provides

a

coherent account of

why

the 1970s

were

different,

and of what

generated

the

observed

dramatic

increases

in

deflator

inflation.

Thus,

the evidence

in

Figure

8

provides

further

support

for

the

monetary explanation

of

the

stagflation

of the

1970s.

7.

The

Relationship of

Oil Prices and

the

Macroeconomy: Theory

In

Section

6,

we

showed

that,

although

an oil

supply

shock

may

well

cause

a

recession,

its

effect on the GDP

deflator

(as

opposed

to

the

CPI)

is

ambiguous

in

theory

and

appears

to be

small in

practice.

Neverthe-

less,

casual

observers

continue to

be

impressed

with

the

coincidence

of

sharp

oil

price

increases

in

the

1970s and

the

worsening

of

stagflation.

In

20.

The

unusually

long delay

in

the

response

of

inflation to

money

can be

explained

by

the

presence

of

wage

and

price

controls

throughout

1973 and in

early

1974. These

controls

effectively

suppressed

inflation

rates. The

lifting

of

price

controls in

April

1974

coin-

cided with a

sharp

increase in

deflator

(as

well as

CPI)

inflation

(see

Blinder,

1979).

The

fact

that

the

increase

in

deflator inflation

rates in

1980-1981

was

smaller

(if

more

sustained)

than in

1974-1975 also is

consistent with

this

interpretation.

166

*

BARSKY

&

KILIAN

fact,

some observers seem

puzzled by

the

absence

of a

close

link

be-

tween oil

prices

and

stagflation

at

other times

(for

example,

The Econo-

mist,

1999).

In

this

section,

we will

argue

that the

almost simultaneous occurrence

of

sharp

increases

in

oil

prices

and

worsening stagflation

in

the 1970s was

indeed

no

coincidence.

Unlike

conventional accounts

based

on

exoge-

nous

oil

supply

shocks, however,

we

stress

that

oil

prices

were

respond-

ing

in

substantial measure to

conditions

in

the oil

market,

which

in

turn

were

greatly

affected

by

macroeconomic

conditions

(and

ultimately by

the

monetary

stance).

Put

differently,

we

reject

the

common notion

of a

sim-

ple

one-way

causal

link from

oil

prices

to the

macroeconomy

and

allow

for

the

possibility

that oil

prices

(like

other

commodity

prices

traded

in inter-

national

markets)

tend to

respond

to

macroeconomic forces.

The view that

oil

prices

contain

an

important endogenous

component

is not

as radical

as

it

may

seem.

In

fact,

the

observed

behavior of oil

and

non-oil

commodity prices

coheres

well with

economic

theory

about re-

source

prices

(see

Heal

and

Chichilnisky,

1991).

Commodity

prices

rise

in

response

to

high output

and

low real

interest

rates. Our

emphasis

on

the

endogenous response

of oil

prices

to

global

(and

in

particular

U.S.)

macroeconomic

conditions does not

rule out that

political

events

played

a

role

in the

timing

of

the

observed oil

price

increases,

but it

suggests

that

politically

motivated

increases

in the oil

price

would have been

far

less

likely

in

the absence of

a conducive economic environment

created

by monetary policy.

The

starting

point

for

our

analysis

is the classic resource

extraction

model of

Hotelling

(1931).

Applying

this model to

oil,

marginal

revenue

(MR)

net of

marginal

cost

of extraction

(MCE)

must rise

at the

rate

of

interest,

so

that

well

owners are on

the

margin

indifferent

between

extracting

oil

today

and

extracting

oil tomorrow.

Further,

the transver-

sality

condition

says

that,

in

the

limit,

no oil should

be

wasted. Combin-

ing

these

two

conditions,

for the

special

case

of zero

marginal

extraction

cost,

we

have

Dtil

(pil

ert,

Yt)

soil

(7)

t=0 _

+

where

poil

=

initial relative

price

of

oil,

Soil

=

fixed stock

of

oil,

r

=

real

interest

rate,

Yt

=

aggregate

output

in

period

t,

and

DQil

=

demand for

oil

in

period

t. Under

perfect competition,

equation

(7)

implies

that the

price

of oil

rises

at the rate of interest

until the

fixed stock

of oil is exhausted.

For

the more

general

case

of

positive

marginal

extraction costs

the first-

Do We

Really

Know

that Oil Caused

the Great

Stagflation?

*

167

order condition

for

profit

maximization

is that MR

- MCE must

rise

at

rate

r:

MR-

MCE

=r.

(8)

MR

-

MCE

Note

that

the

required

rise over time

in MR -

MCE

may

be

accom-

plished by

a fall in

MCE as

new

capacity

is

developed,

even without

a

rise

in

the oil

price

(see

Holland,

1998).

Indeed,

this feature of the

model

allows for the oil

price

to fall

over

time.

This

simple

model

implies

several channels

through

which

monetary

policy

affects oil

prices.

First,

a one-time

permanent drop

in r

raises

the

initial

price,

and

implies

slower

price

growth

thereafter.

Second,

a

rise

in

aggregate

real income

shifts out the flow demand for oil.

Since the oil is

consumed

more

rapidly,

the

price

of oil must

rise to clear the

market.

The

magnitude

of these

effects

depends

on the

size

and duration

of the

effects of

monetary

policy

on

r

and

y.

Money

is not

normally

thought

to

permanently

change

r

or

y.

Thus,

the

magnitude

of

price

adjustment

in

response

to

monetary policy

in

this model

may

not be

large.

Much

stronger

effects on

the

price

of oil

may

occur once

capacity

is

modeled

explicitly.

If

marginal

costs are

increasing

in

the extraction

rate

(which-in

the

limit-may

be

interpreted

as

a

capacity

constraint),

a

shift

in

demand

for

oil

in

this model

may generate

sharp

increases

in

the

price

of oil

as well

as

overshooting

of the oil

price.21

In

the

limit,

if

installed

capacity

is

instantaneously

fixed,

the

price

of oil at a

moment

in

time is

determined

entirely

by

demand.

A

rise

in

real

GDP,

or

a

decrease

in

the

real

interest

rate,

shifts the

demand

curve for oil

to the

right,

sharply raising

the

market

price

of

the

given

stock of oil.

However,

this

price

increase

carries

the seeds

of its

own

destruction.

If

we

began

in

steady

state,

the

shadow

price

of

capacity

will

now

exceed its

replacement

cost at

current

levels of

capacity.

If

the

price

remains

high

for extended

periods,

investment

in

drilling

and

distribution

capacity

takes

place,

and in

the

long

run

the

price

of

oil

will

fall.

In

addition to

the

direct

effects of real

income and

real

interest rates

on

the demand

for

oil,

there

is also an

additional

effect

that

links

the stabil-

21.

Mabro

(1998,

p.

16)

notes

that

".. .

exhaustibility

as an

ultimate

outcome

in

a

universal

context

is not

very

relevant

[for

the oil

price]

because

the time

horizon

involved,

even

today,

is far

too

long

to have a

noticeable

impact.

What

matters is the

relationship

of

current

productive

capacity

to current

demand

and of

planned

investments

in

capacity

to

future demand.

It is

not

the

geo-physical

scarcity

of

oil that

poses problems

.

. .

but

the

capacity

issued at

any given point

in

time."

168

*

BARSKY

& KILIAN

ity

of

oil cartels to

macroeconomic forces.

Standard

theoretical models of

cartels such as

Rotemberg

and

Saloner

(1986)

and

Green

and

Porter

(1984)

predict

that cartel

stability

will

be

strengthened by

low real inter-

est

rates. Producers trade off the

immediate

gains

from

abandoning

the

cartel

against

the

present

value of

the cartel

rents

forgone.

This

logic

suggests

that

the

unusually

low real

interest rates

in

the

1970s,

all

else

equal,

should have

been

conducive to

the

formation

of

cartels,

and the

high

real interest rates

of

the 1980s

should

have

been detrimental.

More-

over,

Green and Porter show

that if

producers,

rather than

observing

the

cartel's

output, only

observe

a

noisy

measure of the

market-clearing

price,

cartel

activity

will

be

procyclical.

The

assumption

of

imperfectly

observable

output

is

particularly appealing

for crude-oil

producers.

The

actual

production

level of

crude

oil

can

only

be estimated

in

many

cases,

and

reliable

output

statistics become available

only

with a

long

lag.

Thus,

we would

expect strong

economic

expansions,

all

else

equal,

to

strengthen

oil cartels and

major

recessions

to

weaken

them.

8. The

Relationship of

Oil

Prices

and

the

Macroeconomy:

Evidence

The

view

that oil

prices

are

endogenous

with

respect

to

U.S.

macroeconomic variables

such

as

real interest rates

and real GDP has

considerable

empirical

support.

The two most

prominent

increases

in

the

price

of oil

in 1973-1974

and

1979-1980

were

both

preceded

by

periods

of economic

expansion

(see

Table

1)

and

unusually

low

real

interest

rates

(see

Figure

5d).

Similarly,

the

most

recent oil

price

increase

coincided

with

a

strong

economic

expansion.

In

contrast,

the

fall in

oil

prices

after 1982 coincided

with

a

severe

global

recession and

unusually

high

real interest

rates. This section

analyzes

in detail the historical

evidence for

a link between oil

prices

and the

macroeconomy.

8.1 WHY

DID THE

1973-1974

OIL PRICE INCREASE

OCCUR

WHEN

IT DID?

An

intriguing

question

is

why

the

two

major

and

sustained

oil

price

increases

of the

1970s occurred

when

they

did. The dominant

view

in

the

literature

appears

to

be

that

the

timing

was

primarily

determined

by

exogenous

political

events

in the Middle

East,

which

are

thought

to have

triggered

supply

cuts,

thereby raising

oil

prices

(see

Hamilton,

1999).

However,

as

we

will

argue,

sustained

oil

price

increases

are

only

possi-

ble under

conditions

of excess

demand

in

the oil

market.

Such condi-

tions

are

unlikely

to occur

in the absence

of favorable

macroeconomic

conditions,

notably

economic

expansion

and low

real interest

rates.

Do We

Really

Know

that

Oil Caused

the Great

Stagflation?

?

169

Thus

the

apparent

success of OPEC oil

producers

in

raising prices

in

the

1970s

(and

their

failure

to

raise

prices

for

sustained

periods

at

other

times)

is no historical

accident. The

timing

of

the

oil

price

increases

in

the

1970s

coincided

with

periods

of

unusually strong

demand for

oil,

driven

in

substantial

part

by

global

macroeconomic conditions.

Until the

late

1960s,

the

excess

capacity

of

the U.S. oil

industry

allowed

the U.S. to

play

the

special

role

of the

supplier

of

last resort

to

Europe

and

Japan,

in

the event that

oil

supplies

were

threatened. The fact

that

the U.S. assumed

this role was an

inadvertent

consequence

of

the

regula-

tory policies

of the

Texas Railroad

Commission

regime,

under which

rationing

of

production

led to

excess

capacity

(see

Hamilton,

1985).

The

ability

of the United

States to flood

the market with

surplus

oil served

as

a

deterrent

against any

attempt

to

raise

international oil

prices,

and

ultimately

thwarted the

effects of the

1956

and

1967 oil

embargoes.

What

then

were the

changes

in

the world

oil market

that

made the

successful

1973 oil

price

hike

possible?

The

main

difference

between

the

early

1970s

and

earlier

periods

was

that,

on

top

of

the

long-term

trend

toward

in-

creased

energy

consumption,

there

was

a

dramatic

surge

in

worldwide

demand for oil that

was

fueled

by

monetary

expansion.

In

March

1971,

U.S. oil

production

for

the

first time

in

history

reached

100% of

capacity

(see

Yergin,

1992,

p.

567).22

The

rising

demand

for oil

was

at

first met with an

increase

in

oil

output

in

the

Middle East that

kept

the

price

of

oil low and

falling

in

real

terms

(see

Figure

9).

Oil

imports

as

a

share of

U.S. oil

consumption

rose from

19%

in

1967 to

36%

in

1973

(see

Darmstadter and

Landsberg,

1976,

p.

31).

Mabro

(1998,

p.

11)

notes

that

OPEC's

average

daily

production

increased from

23.4

million

barrels

per

day

in

1970

to 30.99

million barrels

per

day

in

1973. All

OPEC

members but

Kuwait,

Libya,

and

Venezuela

increased

production

in

this

period.

As

a

result,

excess

capacity

was

shrinking

quickly

in

the

Middle

East.

Seymour

(1980,

p.

100)

documents

that

the oil

market

had

been

tight-

ening

since

1972 in

spite

of the

rapid

increases

in

oil

output.

In

late

1972,

all

of

the

main

market

indicators-tanker

freight

rates,

refined-

product

prices,

and

spot

crude

prices-started

rising

and

continued

their

climb

throughout

1973.

While

the

recoverable

reserves

in

the Mid-

dle

East

were

of

course

huge,

available

production

capacity

was

lagging

consumption.

By

September-October

of

1973,

immediately

before

the

22.

The

normal

market

response

to this

shortage

would

have been

rising

oil

prices.

How-

ever,

U.S.

price

controls

on

oil,

imposed

in

1971 as

part

of

an

overall

anti-inflation

program,

were

discouraging

domestic oil

production

while

stimulating

consumption,

and

left little

incentive for

exploration

or

conservation.

Moreover,

growing

environmen-

tal

concerns

held back

U.S. oil

production,

even

as new

large

oil

reserves

were

being

discovered in

Alaska

(see

McKie,

1976,

p.

73).

170

*

BARSKY &

KILIAN

Figure

9 REAL

PRICE INDICES FOR

CRUDE OIL

AND

FOR

INDUSTRIAL

COMMODITIES,

JANUARY

1948 TO

JULY

2000

1950

1955 1960 1965

1970 1975 1980

1985 1990

1995 2000

Source: See

Figure

6 for

a

description

of the data.

The

price

data

have been deflated

using

the

CPI index

excluding

shelter

(PRXHS).

oil

embargo,

both Saudi Arabia

and Iran had

just

about

reached their

maximum

sustainable

output.

The

capacity shortage

was

not limited to

Saudi Arabia

and Iran. Had

oil

prices

not risen in

late

1973,

there

would have

been

virtually

no

spare productive

capacity

available

any-

where in

the world

on the basis

of the then

projected

forecasts of oil

consumption

for the

winters of

1973-1974 and

1974-1975

(see

Seymour,

1980,

p.

100).23

23.

Our

reading

of the evidence coincides with

contemporary

accounts. For

example,

in

November

1968,

only

one

year

after the

successful defeat of the

1967 oil

embargo,

State

Department

officials announced at

an OECD

meeting

that soon

the U.S. would not

be

able

to

provide

extra

supply

to the world in

the event of an

embargo

(see

Yergin,

1992,

p.

568).

In

November

1970,

a U.S.

diplomat

in the Middle East

filed

a

report

stating

that

"the

extent

of

dependence by

western industrial

countries

upon

[foreign]

oil as a

source of

energy

has

been

exposed,

and

the

practicality

of

controlling

supply

as a

means of

exerting

pressure

for

raising

the

price

of

oil has been

dramatically

demon-

strated"

(Yergin,

1992,

p.

587).

Do

We

Really

Know

that Oil Caused

the Great

Stagflation?

*

171

8.2 IF THE

1973 OIL

PRICE INCREASE

WAS CAUSED

BY

DEMAND

SHIFTS,

WHY DID

OIL OUTPUT

FALL?

The normal market

reaction to the

increased demand for

oil in

the

early

1970s

should have

been

an

increase

in

both

price

and

quantity

of oil.

As

we have

noted,

the

data

instead

show

a

steady

decline of

the

price

of

oil

in

real

terms

in

the

early

1970s,

followed

by

a

sharp

rise

in

the

price

of

oil

in

late 1973 and

a

drop

in

oil

output.

This

puzzling

observation reflected

the

gradual

resolution of a

disequilibrium

that

arose from the

peculiar

institutional

structure of

the OPEC

oil

market at

that

time.

Throughout

the

1960s,

oil

delivery

contracts were

long-term

agree-

ments

between OPEC

producers

and oil

companies.

Oil

producers

agreed

to

supply

oil at

a

price

that was

fixed

in

nominal terms for

several

years

in

advance.

Contracts were

periodically

renegotiated

to

take account

of

changes

in

economic

conditions. As the

macroeconomic

environment

became

increasingly

unstable

in

the

early

1970s,

the

renegotiations

failed

to

keep

pace

with

the

rapidly

changing

macroeconomic

conditions.

The

stickiness of the

nominal

oil

price

contributed to the

observed

fall

of

the

real

price

of

oil,

as

inflation

outpaced

expectations.

OPEC

producers

be-

came

increasingly

reluctant

to

supply

additional

quantities

of

oil

at

prices

well

below the

market-clearing

level.

By

late

1973 this

regime

came

to

an

abrupt

end,

when

OPEC

reneged

on its

contractual

agreements

with

the oil

companies

and

unilaterally

decreed

a

much

higher price

of

oil.

As

the

price

of oil

rose

sharply,

the

quantity

of

oil

fell,

lending

credence to the view that a

contemporaneous

shift

in

the

supply

of oil had

taken

place.

It

is

common to

attribute the

fall in

oil

output

and the

rise

in

the

price

of oil

to

the 1973 war

and

the

subsequent

oil

embargo

(see

Hamilton,

1999).

As

we will

show,

this

interpretation

is

by

no

means

obvious,

because

excess demand in

the oil

market

would

have

induced an

unprecedented

increase

in

oil

prices

at

the

end of

1973,

even

in

perfectly competitive

markets.

For

expository

purposes

consider

a

two-period

model of

the oil

market

dynamics

in

the

early

1970s

(see

Figure

10).

In

period

1,

starting

from

the

equilibrium

point

A,

a

shift

in

demand

for oil

as

a

result

of

expansionary

monetary

policy

raises

the shadow

price

for oil.

The new

market-clearing

price

at

point

B,

however,

is

never

realized,

because the

price

of

oil is

effectively

held

back

by

long-term

contractual

agreements

(see

Penrose,

1976).24

Instead,

we

move from A

to

C,

corresponding

to an

increase

in

24.

The

essential

point

here is that

the

price

of oil in

the

early

1970s

remained

substantially

below

market-clearing

level in

the

presence

of

excess

demand. The

assumption

of a

fixed

price

is

an

oversimplification

designed

to allow

us to

abstract

from

the

effects of

inflation.

The

price

of oil

actually

fell in

real

terms

in

the

early

1970s,

despite

efforts

by

OPEC

to

offset

these

losses

(see

Figures

6 and

9).

172

*

BARSKY

& KILIAN

Figure

10

A

TWO-PERIOD

DISEQUILIBRIUM

ANALYSIS OF

THE

OIL

MARKET

t'?

D'

S

P"

D'\ /

O O

Period

I

Period

2

Notes:

In

period

1,

starting

from the

equilibrium point

A,

a shift

in

demand for oil as

a

result of

expansionary

monetary

policy

raises the shadow

price

for oil. Given the fixed contractual

price

of

oil,

production

increases

and we move to C.

In

period

2,

OPEC

reneges

on the contractual

price,

and raises

the

oil

price

to the

market-clearing

level

D while

reducing

the

quantity supplied.

the

quantity

of

oil

supplied

at the old

price.

In

period

2,

OPEC

reneges

on

the contractual

price,

and

raises the

oil

price

to the market

clearing

level

(D=B)

while

reducing

the

quantity supplied.

The

price

and

quan-

tity

movements

in

period

2

have the

appearance

of

an

oil

supply

shock,

yet

the

supply

curve

never

shifts;

we

are

witnessing

the correction

of

a

disequilibrium

resulting

from the earlier demand

shift.

Our

stylized

model of

the 1973-1974 oil market

dynamics

is consistent

both

with the absence of

significant

increases

in

the real

price

of

oil and

the observed

increase

in

oil

production

in

the

early

1970s.

It

also

is

consistent

with

the

fall

in

the

quantity

of

oil

produced

and the

sharp

increase

in

the

OPEC oil

price

in

1973-1974.

The 1973-1974

episode

illustrates

the

point

that fundamental identification

problems

need to be

addressed before

we

can

assess the effect of

exogenous

political

events

in

the

Middle East on

the

price

of oil.

As we have

shown,

the observed

price

and

quantity

movements

in

1973-1974 are consistent

both with

supply

interruptions

and

with the restoration

of

equilibrium

after

the

removal

of

price

ceilings.

Our

model also

is consistent

with

the

views

of

oil economists

such as

Mabro

(1998,

p.

10)

that

"a

major political

crisis

will not cause

a

price

shock

when

capacity

cushions

exist

in

other

coun-

Do

We

Really

Know that Oil

Caused

the

Great

Stagflation?

*

173

tries,

while

excess demand would

cause

prices

to flare even

in

the ab-

sence

of

any political

crisis."

The

fact that the cumulative rise

in the

oil

price

did not exceed the

cumulative increase

in

other

industrial

commodity prices suggests

that

the actual oil

price

in

January

1974 was

probably

not far from the

market-

clearing

level. As we

will

argue

later,

OPEC market

power played

a

more

important

role

in

determining

the

price

of oil

only

after

January

1974,

when OPEC

attempted

to stabilize

the

price

of

oil at

its

peak

level,

even

as

the U.S.

economy

slid into recession

and

other

commodity prices

fell

sharply.

An

alternative

interpretation

of

the oil

price

increase

of 1973-1974 has

been

proposed by

Hamilton

(1999).

Hamilton stresses the role of

oil

supply interruptions

that are

exogenous

to

the

state

of

the

U.S. macro-

economy.

He discusses several such

supply interruptions

that

in

his

view

were

caused

by "military

conflicts"

and

"wars"

[including

(1)

the

October 1973

war,

(2)

the Iranian

revolution

of late

1978;

(3)

the outbreak

of

the

Iran-Iraq

war in

September

1980,

and

(4)

the Gulf war of

1990-

1991].

There is

some

doubt, however,

about the

extent to which

these

events were

truly exogenous.

Hamilton

is

not

explicit

about the nature

of the

causal

link

from

military

conflict

to

exogenous production

cut-

backs.

In

some

cases,

for

example

in

discussing

the

Gulf war

(p.

28)

or

the

Iraq-Iran

war

(in

his

Appendix

B),

he

clearly

has

in

mind

the

physi-

cal destruction

of

oil

facilities

and

the war-induced

disruption

of oil

shipping.25

In

contrast,

the

production

cutbacks

in

late 1973

clearly

were

not

caused

directly

by military

conflict.26

In

fact,

most of the

production

cutbacks

occurred

only

after

the war

(which

lasted from

October

6

to

October

23,

1973)

as

part

of

an

oil

embargo

by

Arab

oil

producers.

In

his

Appendix

B,

Hamilton

postulates

a

causal

link

from

the

October

war

to this oil

embargo.

This

link

is

questionable.

Unlike

the

war

itself,

the oil

embargo

is not an

exogenous

political

event.

There

is

considerable

evidence

that

oil

producers

carefully

considered the

economic

feasibility

of the oil

embargo.27

In

fact,

the oil

embargo

was

contemplated

as

early

25.

Hamilton

(1999,

p.

28)

refers to "a

number of

historical

episodes

in

which

military

conflicts

produce

dramatic and

unambiguous

effects on the

petroleum production

from

particular

fields" such

as the

Iraqi

invasion of Kuwait in

July

1990.

26.

During

this war

only Syrian

and

Iraqi

oil

facilities

sustained battle

damage.

Neither

country

was

a

major

oil

producer,

and

the

loss

of

oil

output

was small.

The

bulk

of the

reduction

in

oil

output

that did

occur

in

late 1973

can be attributed

to

countries that

were not

directly

involved in

the

war,

but

chose to

restrict

output,

notably

Saudi Arabia

and

Kuwait

(see

U.S.

Energy

Information

Administration,

1994,

p.

307).

27. An

early example

is

King

Faisal

of Saudi

Arabia's

rejection

in

1972 of

the use of

the oil

weapon

on

economic

grounds

(see

Terzian, 1985,

p.

164).

That

decision

was reversed in

late

1973,

when more

than

a

third of

U.S. oil

consumption

was

accounted

for

by

174

*

BARSKY & KILIAN

as

July

1973,

well

before

the

October war

(see

Arad

and

Smernoff, 1975,

p.

124),

and

United States

officials were

aware of that threat.28

Although

some countries

announced

a

first

stage

of

production

cuts as

early

as

October

18

(in

the

last

week of the

war),

the

embargo

was

tightened

only

after

hostilities

had

ended on

October

23. Not

surprisingly,

the

oil em-

bargo

was lifted without its

original

political

goals being

achieved,

as

soon as oil

prices

had reached a

sufficiently high

level. Concern for

the

Arab cause lasted

only

as

long

as

it

was

economically expedient.

Moreover,

contrary

to

popular

perception

(see

the

quotation

from the

Economist

in

Section

1),

the oil

embargo

was

not associated with

a

quadru-

pling

of oil

prices.

In

actuality,

the

price

increase

that

coincided

with the

embargo

was

only

half as

large.

The

other

half

of

the oil

price

increase

occurred well before the

embargo.

In

1971,

the

basic

structure of

the

con-

tractual

agreements

between oil

companies

and

OPEC countries had

been

renegotiated

at

conferences

in

Teheran and

Tripoli.

These

agree-

ments were

long-term

in nature.

Neither the

oil

companies

nor the

OPEC

governments

anticipated

the

subsequent

successive dollar deval-

uations

in

1971

and

1973,

the

rapid

rise

in

U.S.

inflation,

and the

extraor-

dinary surge

in

the

demand for oil

in

1972 and 1973.

In

response

to these

events,

OPEC countries

and

oil

companies

repeatedly

renegotiated

the

conditions

of their contracts.

Posted

prices

of

light

Arabian

crude

gradu-

ally

rose

from

$2.29

in

June

1971

to

$2.90

in

February

1973.

In

June

1973,

pressure

mounted to abandon the

framework

of

Teheran

and

Tripoli

and

for

governments

to set

posted prices unilaterally. By

September

1973,

all the

OPEC countries were

prepared formally

to re-

quest

a

revision of

the

price agreements,

as

the

gap

between market

prices

and

posted prices

widened.

Negotiations opened

on

October

8,

two

days

after

the outbreak

of the

October 1973

war. OPEC

proposed

to

raise

the

price

of

oil to

$5.12.

The

oil

companies

stalled for time. On

October

16, 1973,

OPEC

renounced

the Teheran

and

Tripoli

agreements

and

unilaterally adopted

the

proposal

they

had earlier

put

before

the

companies.

As Penrose

(1976,

p.

50)

notes,

"the October

1973 increases

imports.

Similarly, during

the

1971

Teheran

negotiations

between

the

major

oil

compa-

nies,

the Gulf states threatened

to

implement

an

oil

embargo,

but

never

implemented

it.

Again, during

Israel's invasion

of

Lebanon

in

1982-which coincided

with

high

oil

prices,

a

global

recession,

and

high

real interest rates-an

oil

embargo

was considered

by

the

Organization

of

Arab

Petroleum

Exporting

Countries,

but

rejected

as

inconsis-

tent

with the

economic

interests

of the

organization

(see

Yergin,

1992,

pp.

582, 719;

Skeet,

1988,

p.

187).

28. Arad

and

Smernoff

(1975,

p.

190)

note

that

in

July

1973 the Committee

on

Emergency

Preparedness

of the National

Petroleum Council issued

a

report

that concluded

that an

interruption

of

petroleum imports

into

the

U.S.

was

likely

as

early

as

January

1974,

based on data

on the

dependence

of the U.S.

on

oil

imports.

Do

We

Really

Know that

Oil Caused

the Great

Stagflation?

*

175

in

posted

prices

were

not related

to the

war,

but to the

fact that

the

assumptions underlying

the

Teheran

agreement

had

proved

unjustified.

The

exporting

countries therefore felt

that

the

.

prices agreed upon

in

Teheran

required

adjustment

to the new market and

monetary

condi-

tions. These conditions

were

not,

in their

view,

of their own

making,

since

they

had

not

cut

back

supplies

...

."

In

fact,

the

quantity

of

oil

supplied by

OPEC

had

gradually

increased

from 29.9 million

barrels

per

day

in

January

1973 to 32.7 million

barrels

per

day

in

September

1973.

Thus,

as we showed

earlier,

not

only

are there

strong

reasons to doubt

that

the second

doubling

of oil

prices

on

January

1,

1974,

was caused

by

exogenous

oil

supply

cuts,

but

there

is

overwhelming

evidence that

the

initial

doubling

of the

oil

price

to

$5.12/barrel

was due

to increased

demand for oil.

8.3 WHY DID THE

1979-1980

OIL PRICE INCREASE

OCCUR

WHEN

IT DID?

We now

turn to

the second

major

oil

price

increase

of

the

1970s,

which

took

place

in

1978-1980. As in

the

early

1970s,

there is

clear

evidence of

an

output

boom,

unusually

low

real

interest

rates,

and

rising

inflation

prior

to 1980.

The

rapid

growth

was

fueled

by

the

renewed

world-wide

monetary expansion

documented

in

Section

4.

Although

this

expansion

was

reflected

in a

sustained

increase

in

industrial

commodity

prices

in

1976-1979,

the increase in

other

commodity

prices

was

dwarfed

by

the

increase

in

oil

prices

that

started

in

late

1978

(see

Figure

6).

Since the

surge

in

oil

prices

not

only

far

exceeded inflation

adjustments,

but

also

was

not

supported

by

a

corresponding

tightening

in

other

commodity

markets,

it

must

have reflected

additional

developments

specific

to the

oil

market.

Judging

by

the

increase

in

other

industrial

commodity

prices

in

1978-1979,

at

best

one-third of

the actual oil

price

increase

appears

to be

consistent

with the

monetary

model.

In

that

respect,

the

second oil

crisis

appears

fundamentally

different from

the first

oil

crisis

of

1973-1974.29

The

inability

of

the

monetary

model

to

explain

more than

one-third

of

the

oil

price

increase

in

1979-1980 does not

imply

that

the

other

two-

thirds of

the

increase was

due

to

oil

production

cutbacks

caused

by

the

Iranian

revolution in

late 1978

and

the

outbreak

of the

Iran-Iraq

war in

September

1980,

as

suggested

by

Hamilton

(1999).

First,

taking

into

29.

Also

note

that,

unlike in

1973-1974

when

oil

prices

doubled in

a

single day,

the oil

price

increase in

1979-1980 was

much

more

gradual.

One

reason is

that-unlike in

the

early

1970s-OPEC oil

prices

had not

been held

back

by

what

was

effectively

a

price

ceiling.

Thus,

the

observed oil

price dynamics

cannot be

explained

by

a

disequilibrium

adjust-

ment

of the

kind

described in

Figure

7.

176

*

BARSKY & KILIAN

account the

offsetting production

increases

by

other oil

producers

such

as

Saudi

Arabia,

the

production

shortfall

in

early

1979

was not

nearly

as

dramatic

as

suggested by

Hamilton

(1999).

Global

production

in

Octo-

ber, November,

and December 1978

exceeded the

September

1978 level.

Only

in

January

and

February

of

1979,

at

the

height

of turmoil

in

Iran,

did

global

oil

production

fall

significantly

below its

September

1978

level,

by

4%

and

3%,

respectively

(see

U.S.

Energy

Information Administra-

tion, 1994,

p.

312).30

Moreover,

total

annual OPEC oil

production

in

1979

was 4%

higher

than

in

1978

(see

Skeet, 1988,

p.

244).

Second,

the

timing

of the

oil

price

increase

suggests

that

physical

production

shortfalls

narrowly

defined are not the cause of the

oil

price

surge.

The bulk

of the

oil

price

increases occurred

well after

the

Iranian

revolution was over

and well before the outbreak

of

the

Iran-Iraq

war.

Specifically,

during

the

Iranian

revolution,

between October

1978

and

April

1979,

the

average price

of U.S.

oil

imports

rose

by only

about

$3/

barrel

(see

DRI

database).

In

February

1979,

Iran

announced

the

resump-

tion

of

exports,

and

by

April

1979,

global

oil

production

matched

the

September

1978 level. The

main

surge

in

oil

prices

began only

in

May

1979,

at a time when

global

oil

production

exceeded

its

September

1978

level

(see

U.S.

Energy

Information

Administration,

1994,

p.

312).

Be-

tween

May

and October

1979

alone,

oil

prices

rose

from

$19

to

$25

per

barrel.

Oil

prices

continued to climb

to almost

$34

by April

1980,

when

the

armies

of

Iran and

Iraq

were first

put

on

alert

(see

Terzian,

1985,

p.

279).

The

war broke

out

in

September

1980.

In

December

1980,

oil

was

still

under

$36.

It

finally

rose to

a

peak

of

$39

in

February

1981.

One

explanation

of the

additional oil

price

rise

that occurred

between

mid-1979

and mid-1980

that

has been

proposed

in

the

literature

is

a

temporary

surge

in

precautionary

demand

in

response

to increased

un-

certainty

about

future

oil

supplies

and

expectations

of

strong

future

demand

(see

Adelman,

1993,

p.

428).

The

uncertainty-based explanation

of

higher

oil

prices,

however,

does not

seem

plausible

in

the

absence

of

taut demand

conditions

in

the oil

market,

which

in

turn

were

driven

in

no

small measure

by

a

booming

world

economy

and low

real

interest

rates.

The

fact

that

a

large

number

of

military

conflicts

and incidents

in

the

Gulf

region

in

subsequent

years

did not

lead

to

sustained

increases

in oil

prices

suggests

that

increased

Middle

East

uncertainty

appears

to

have little or

no

effect

on oil

prices

in the

absence of

favorable

macro-

30.

Hamilton notes

that

Iranian cutbacks

in

January

and

February

1979 amounted

to

almost

9%

of

the

average

monthly global

oil

production

for

1978.

Using

the same data

source,

after

allowing

for

production

increases

elsewhere,

global

oil

production

in

January

and

February

1979

actually

matched or

exceeded

slightly

the

average

1978 level

(see

U.S.

Energy

Information

Administration,

1994,

p.

312).

Do

We

Really

Know that Oil Caused the Great

Stagflation?

*

177

economic

conditions.31

It

is no

coincidence

that oil

prices

(as

well as

non-

oil

commodity prices) peaked

shortly

after Paul

Volcker launched a

sharp

monetary

contraction

resulting

in

a

global

recession

and

high

real

inter-

est

rates.

Weakening

demand

played

a crucial role

in

undermining

Saudi

Ara-

bia's efforts to shore

up

the oil

price

between 1982

and 1985

by reducing

oil

supply.

The fact that other

OPEC members

undercut the official

OPEC

price

in 1982-1985

appears

consistent

with the view

that,

in

the

absence

of

effective

monitoring

and

punishment,

cash-starved

oil-producing

countries

(such

as

Iraq

and

Iran)

had an incentive to

undercut the cartel

price

in

order

to

increase

current revenue.

At the same

time,

competition

from

other oil

producers

increased.

By

the

early

1980s,

a

large

number of

new oil

suppliers

such as

Egypt,

Angola, Malaysia,

China,

Norway,

and

the United

Kingdom

had entered

the market

in

response

to the unusu-

ally

high

oil

prices

of

the

1970s,

while

existing

producers

including

the

United States

(Alaska),

Mexico,

and

the USSR

had invested

in

new

capac-

ity

and

expanded

oil

production. By

1982,

less than

half

of

world

oil

was

supplied

by

OPEC,

compared

with two-thirds

in

1977

(see

Skeet, 1988,

p.

201).

The

resulting

downward

pressure

on oil

prices

is

consistent

with

the

predictions

of

the

Hotelling

model with

capacity

constraints.

We do not

attempt

to address

in

this

paper

the

reasons

for the

long

delay

in

the decline

of

oil

prices-both

in

the

mid-1970s

and

in

the

early

1980s-after

the initial

monetary expansion

was

reversed.

Although

the

sharp

oil

price

increases

in

the

1970s

came on

the

heels

of shifts in

the

demand

for

oil

that-in

our

view-were

directly

or

indirectly

fueled

by

monetary expansion,

OPEC seems to have been

adept

at

restraining

official

price cutting

even

in

the

presence

of

significant

excess

capacity.

Figure

8 shows that

other industrial

commodity

prices dropped

sharply

in

response

to

recessions

and

higher

real

interest

rates,

as

theory

would

suggest.

Oil

prices,

however,

remained at a

much

higher

level

than

31.

Examples

include the Israeli attack on an

Iraqi

nuclear

reactor

in

June

1981;

a

state

of

near-war

between

Israel

and

Syria

from

April

to

July

1981

(see

Skeet,

1988,

p.

181);

the

invasion of

Lebanon

by

Israel in

June

1982;

the Iranian Ramadan

offensive

against Iraq

in

July

1982

(see

Yergin,

1992,

p.

764);

Iran's

threat

in

July

1983

to

blockade the

Straits

of

Hormuz

(see

Terzian, 1985,

p.

323);

suicide attacks on the U.S. and

French

headquar-

ters in

Lebanon

in

October 1983

(see

Skeet

1988,

p.

197);

the

tanker

war

in

the Gulf

in

February-April

1984,

during

which at least

eleven tankers and the

major

Iranian oil

terminal

were hit

(see

Terzian,

1985,

p.

327;

Yergin,

1992,

p.

743);

the

Iranian

capture

of

the Fao

Peninsula in the

southeastern corner

of

Iraq

in

February

1986,

followed

by

Iranian

artillery

and

missile attacks on

Kuwait's oil

ports

and Iranian

naval

attacks on

Kuwaiti

shipping;

the Kuwaiti

request

for U.S. naval

patrols

in

the Gulf in

March 1987

to

protect

its

oil

tankers

(see

Yergin,

1992,

p.

765);

the

Iraqi

missile attack on the

U.S.S.

Stark

during

the tanker war in

May

1987,

resulting

in

the

deaths of 36

sailors;

and

the

downing

of an Iranian

airliner

by

U.S. forces in

the Gulf in

July

1988

following

skir-

mishes

with

Iranian

patrols

(see

Yergin,

1992,

p.

766).

178

*

BARSKY &

KILIAN

other

commodity

prices

during

1974-1978 and

again during

1981-1985.

This

differential

response after

the

onset of the

1974-1975

and

1981-1982

recessions

is

suggestive

of the use

of OPEC market

power

to

prop up

oil

prices.

As

Nordhaus

(1980,

p.

367)

notes,

in

periods

of

excess

demand,

there

is

little OPEC

can do

(or

would

want to

do)

to

impede

oil

price

increases. Once

official OPEC

prices

have

risen, however,

they

tend

to

be

sticky,

even when

there

is a

glut

in

the

oil market.

Indeed,

empirical

and

anecdotal

evidence lends

support

to the view that

OPEC was

most

influential not in 1973-1974 or in

1979

during

the time

of

the most

rapid

oil

price

increases-as

popular opinion

would

suggest-but

in

prevent-

ing

oil

prices

from

falling

as

rapidly

as

they

should

have

when oil de-

mand

subsided

(also

see

Mabro,

1998,

pp.

10-11).

9. Lessons

from

the Most Recent

Oil Price

Surge

The

tripling

of oil

prices

after 1998

provides

us with

yet

another

opportu-

nity

to

test

the

implications

of

our

explanation

of

stagflation.

Historically,

as

we

have shown

in

Section

6,

oil

price

increases

by

themselves have

caused

excess CPI inflation

(relative

to inflation in

the GDP

deflator)

for

short

periods,

rather

than

extended

periods

of inflation. The current

episode

is no

exception.

U.S.

data after

1998 show

a

spike

in CPI infla-

tion relative

to

deflator

inflation

rates

(see

Figure

8).

In

contrast,

there

has been little movement

in

the

inflation

rate

of

the deflator.

This

finding

is not

surprising,

because

there

has not been

a

major monetary expan-

sion

of the kind that

was

characteristic of the 1970s. Also

noteworthy

is

the fact

that,

despite

higher

oil

prices,

there is no evidence

yet

of

a

major

contraction,

which

seems to belie the notion that oil

price

increases

inevitably

cause

recessions.

Although

real

interest rates have

not been

unusually

low,

cumulative

growth

rates

for the United States have been

extraordinarily high-high

enough

to offset

the

less

than stellar

growth

performance

of

Europe

and

Japan.

That increase

in

output,

however,

appears

to

be different

from

the

rapid output growth

in the

1970s

that was

largely

fueled

by

mone-

tary

expansion.

The

very

strong

real

growth

in

the

past

several

years,

especially

in

the

U.S.,

has

been

reflective

of an

increase

of

potential

output

rather

than "demand"

generated

(see

Basu,

Fernald,

and Sha-

piro,

2000).

Our

analysis

suggests

that this

strong growth

in

output

was

instrumental

in

supporting

the increase

in oil

prices

in 1999-2000.

If the

United

States

had

been

in

a

recession

during

1999-2000

and U.S.

de-

mand for oil

had been

low,

it

would

have been

hard for OPEC

to

enforce

high

oil

prices

over

extended

periods.

The

ability

of a cartel like OPEC

to sustain

prices

above the

competitive

level

depends

on

a

conducive

macroeconomic environment.

If there is

a

significant

contraction

of

Do We

Really

Know that

Oil Caused

the Great

Stagflation?

?

179

the

economy,

historical

experience

suggests

that OPEC

will have

an

uphill

battle

maintaining

the current level

of oil

prices.

Both oil

and

other

commodity prices

fell

sharply

after

the Asian

crisis,

yet

only

oil

prices

have

strongly

rebounded.

This

discrepancy

is

sugges-

tive of

a

larger

role for OPEC after 1998

than in

earlier

episodes.

One

interpretation

we can rule out for

sure is

that

OPEC

has been

reacting

to

exogenous political

events in the

Middle East.

Certainly,

the latest

major

oil

price

increase was not

preceded

by physical production

cutbacks

"induced

by

war"

along

the

lines of

Hamilton

(1999).

In

fact,

oil

prices

rose

during

the

period

of

peace

making

between Israel

and

the Palestin-

ians,

but Arab

leaders refused to use the "oil

weapon"

when

the recent

confrontations

erupted

(see

Washington

Post,

2000).

This is

not

surpris-

ing, given

the

already

high

level of oil

prices,

and

certainly

is consistent

with

our

view

that

in

factors

were allowed to

play

a

role

in

setting

oil

prices only

to

the extent

that

they

did not

conflict

with

economic

objectives

and constraints.

What

then

enabled

OPEC to consolidate its

power

after its

influence

had

declined ever

since the late 1980s?

There are two

reasons. One

is

that

other

oil

producers

(such

as

Norway

and

Mexico)

that

are not

part

of

OPEC

effectively joined

forces with

OPEC,

raising

the

organization's

effective market

share,

which

had

declined

dramatically

in

the

1980s

(see

New York

Times,

2001).

The

consolidation of OPEC

is consistent with

theoretical

models of

cartels,

such as

Green

and

Porter

(1984),

that

lead

us to

expect

that

cartels

will

flourish

in

periods

of

strong

economic

growth.

Second,

there is

evidence that oil

producers

across

the

world,

with

the

possible

exception

of Saudi

Arabia,

were once

again

operating

close to

capacity,

and that

few

additional oil

supplies

were

likely

to be

forthcoming

in

the

short run.

This

scarcity

was

arguably

driven in

impor-

tant

part by

strong

demand for

crude oil.

The rise

in

oil

prices

coincided

with a

shortage

of

oil

tankers,

and

freight

rates for

crude oil

shipments

have

increased

sharply,

suggesting high

demand

for oil.

Thus,

the

prob-

lem

appears

to have

been

one of

insufficient

inventories

in

the face

of

rapidly

rising

demand for

oil,

rather than a

global

supply

cut.

This

view is

further

supported

by

the

sharp

drop

of

crude-oil

prices

in

late

December

2000 from

a

peak

of

more than

$37

per

barrel to

below

$27

upon

news

reports

of

an

impending

U.S.

recession,

despite

low

invento-

ries,

Middle East

turmoil,

one

of

the

coldest

winters

in

recent

memory,

and

the

high

likelihood that

most of

Iraq's

oil

exports

would

remain off

global

markets.

Predictably,

OPEC

will

attempt

to

stem

the

expected

decline

in

oil

prices by

announcing production

cutbacks,

as

it

did

after

each

of the

major

oil

price

increases

in

the

1970s when

demand

for oil

began

to

slacken

(see

New

York

Times,

2001).

How

long

OPEC will

be

able

to

sustain

high

real

oil

prices

will

depend

on

the

depth

of

the

economic

180

*

BARSKY

&

KILIAN

downturn as

well as the extent to

which new

non-OPEC oil

supplies

will

be

forthcoming

in

response

to

higher

oil

prices.

10.

Concluding

Remarks

The

origins

of

stagflation

and the

possibility

of its

recurrence

continue to be

an

important

concern

among

policymakers

and in

the

popular

press.

Our

analysis suggests

that in

substantial

part

the

Great

Stagflation

of

the 1970s

could have been

avoided,

had

the Fed not

permitted

major

monetary

ex-

pansions

in the

early

1970s.

We

demonstrated that the

stagflation

ob-

served

in

the 1970s is

unlikely

to

have

been caused

by

supply

disturbances

such

as

oil shocks.

This

point

is

important,

because

to

the

extent

that

stag-

flation is

due to

exogenous supply

shocks,

any

attempt

to

lower

inflation

would worsen

the

recession.

In

contrast,

if

we

are

right

that

stagflation

is

first

and foremost

a

monetary phenomenon,

then

stagflation

does

not

present

an

inevitable

"policy

dilemma." We conclude

that

oil

price

in-

creases

by

themselves are

unlikely

to

reignite

stagflation,

as

long

as the

Federal Reserve

refrains

from

excessively

expansionary

monetary poli-

cies.

Moreover,

a

sustained

increase

in

the

real

price

of oil

is

unlikely

in

the

absence of

a conducive

macroeconomic environment

in

OECD countries.

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Sluggish

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January

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Errors

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Comment

183

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the

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of

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Paper.

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E.

(1976).

The

development

of crisis.

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R.

Vernon

(ed.).

New York:

Norton.

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S.

(1984).

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1978-1982.

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K.

(1985).

The

optimal degree

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an

intermediate mone-

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Quarterly Journal

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100:1169-1190.

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J.

(1982).

Sticky

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the United States.

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Political

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90(6):1187-1211.

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(1996).

Prices,

output,

and

hours:

An

empirical analysis

based on

a

sticky

price

model.

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of Monetary

Economics

37(3):505-533.

,

and G.

Saloner.

(1986).

A

supergame-theoretic

model of business

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and

price

wars

during

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,

and M.

Woodford.

(1996).

Imperfect competition

and

the

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of

en-

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28(4),

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1:

550-577.

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P. A.

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Worldwide

stagflation.

In

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Scientific

Papers,

Vol.

4. H.

Nagatani

and K.

Crowley

(eds.).

Cambridge,

MA:

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1977.

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T.

J. (1998).

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Hoover Institution.

Seymour,

I.

(1980).

OPEC: Instrument

of Change.

London:

Macmillan.

Skeet,

I.

(1988).

OPEC:

Twenty-Five

Years

of

Prices and Politics.

Cambridge:

Cam-

bridge University

Press.

Taylor,

J. (1979).

Staggered

wage

setting

in a

macro model. American Economic

Review

69(2):108-113.

Terzian.

P.

(1985).

OPEC: The Inside

Story.

London: Zed Books.

United

States

Energy

Information

Administration.

(1994).

Historical

Monthly

En-

ergy

Review: 1973-1992.

U.S. Government

Printing

Office.

Washington

Post.

(2000).

Arab

leaders meet for summit.

October

21.

Yergin,

D.

(1992).

The Prize. The

Epic

Quest

for

Oil,

Money,

and Power.

New York:

Simon and

Schuster.

Comment

OLIVIER

BLANCHARD

Massachusetts

Institute

of

Technology

1.

Introduction

Revisionist

history

is

always

fun.

But it is

not

always

convincing.

I

have

enjoyed

thinking

about the

thesis

developed

by Barsky

and

Kilian. But I

am

not

convinced.

Comment

183

the measurement

of

the

output gap

and

the

design

of

monetary policy.

Board

of Governors of the Federal Reserve. Discussion

Paper.

Penrose,

E.

(1976).

The

development

of crisis.

In The Oil

Crisis,

R.

Vernon

(ed.).

New York:

Norton.

Roberts,

S.

(1984).

Who Makes

the

Oil Price?

An

Analysis of

Oil

Price Movements

1978-1982.

Oxford: Oxford Institute for

Energy

Studies.

Rogoff,

K.

(1985).

The

optimal degree

of

commitment

to

an

intermediate mone-

tary target.

Quarterly Journal

of

Economics

100:1169-1190.

Rotemberg,

J.

(1982).

Sticky

prices

in

the United States.

Journal

of

Political

Economy

90(6):1187-1211.

.

(1996).

Prices,

output,

and

hours:

An

empirical analysis

based on

a

sticky

price

model.

Journal

of Monetary

Economics

37(3):505-533.

,

and G.

Saloner.

(1986).

A

supergame-theoretic

model of business

cycles

and

price

wars

during

booms. American Economic Review 76:390-407.

,

and M.

Woodford.

(1996).

Imperfect competition

and

the

effects

of

en-

ergy price

increases

on

economic

activity.

Journal

of

Money,

Credit,

and

Banking

28(4),

Part

1:

550-577.

Samuelson,

P. A.

(1974).

Worldwide

stagflation.

In

Collected

Scientific

Papers,

Vol.

4. H.

Nagatani

and K.

Crowley

(eds.).

Cambridge,

MA:

The

M.I.T.

Press,

1977.

,

and

R. M.

Solow.

(1960).

Analytical aspects

of

anti-inflation

policy.

American

Economic Review

40(2):177-194.

Sargent,

T.

J. (1998).

The

Conquest

of

American

Inflation.

Hoover Institution.

Seymour,

I.

(1980).

OPEC: Instrument

of Change.

London:

Macmillan.

Skeet,

I.

(1988).

OPEC:

Twenty-Five

Years

of

Prices and Politics.

Cambridge:

Cam-

bridge University

Press.

Taylor,

J. (1979).

Staggered

wage

setting

in a

macro model. American Economic

Review

69(2):108-113.

Terzian.

P.

(1985).

OPEC: The Inside

Story.

London: Zed Books.

United

States

Energy

Information

Administration.

(1994).

Historical

Monthly

En-

ergy

Review: 1973-1992.

U.S. Government

Printing

Office.

Washington

Post.

(2000).

Arab

leaders meet for summit.

October

21.

Yergin,

D.

(1992).

The Prize. The

Epic

Quest

for

Oil,

Money,

and Power.

New York:

Simon and

Schuster.

Comment

OLIVIER

BLANCHARD

Massachusetts

Institute

of

Technology

1.

Introduction

Revisionist

history

is

always

fun.

But it is

not

always

convincing.

I

have

enjoyed

thinking

about the

thesis

developed

by Barsky

and

Kilian. But I

am

not

convinced.

184

*

BLANCHARD

2.

The Noncontroversial Part: The

Role

of Money

in the

Early

1970s

Not

all

of the

paper

is

revisionist; indeed,

some of

it

is less so than it

sounds: There

is,

I

believe,

wide

agreement

that

money played

a

major

part

in what

happened

in

the

early

to mid-1970s. Most

observers

would

in

particular

agree

to

the

following propositions

(much

of

what follows

can,

for

example,

be found

in

the book

by

Michael

Bruno and

Jeffrey

Sachs

on

the

Economics

of Stagflation,

published

in

1985):

Expansionary monetary

policy

was an

important factor

in

stimulating growth

and

reducing

unemployment

in

the United States

after

the 1970 recession.

By

1973,

the

unemployment

rate

was

4.9%, downfrom

6.0% in

1971.

U.S.

inflation

came down until

1972,

and then

started

increasing

in

1973,

suggesting

that the

unemployment

rate was then close

to

the

natural

rate. It is

therefore likely

that,

had the

output

expansion

continued at the same rate

after

1973,

inflation

would have

further

increased,

even absent

any

changes

in the

relative

price of

oil.

Expansionary monetary

policy

in the

United

States,

and the

attempts byforeign

central

banks to maintain the value

of

the

dollar,

led to

large

induced

monetary

expansions

abroad.

Growth

in the

other

major

OECD

countries-countries,

which

in contrast to the United

States,

had

not had a recession in 1970-

continued

to be

high. Unemployment

continued to

be

very

low.

Inflation

in

the

EEC

steadily

increased,

nearly doubling

between 1970 and 1973.

There

again,

a slowdown

in

activity

was

clearly

needed,

and would have

come,

even

absent

the

increase in the

price

of

oil.

This world

monetary

expansion

was associated

with low nominal interest

rates,

and

even lower real

interest rates.

This,

combined with

strong

world

demand,

was more than

enough

to

trigger

an increase

in the

price

of

commodities and

raw

materials some time

before

the

increase

in

the

price

of

oil.

In

short,

even

absent the

increase

in

the

price

of

oil,

1974 and 1975

would

have seen either

increasing

inflation

and/or

a

slowdown

in

growth.

Most

likely, given

the attitude

of central

banks from

1973

on,

the

outcome

would have

involved

monetary tightening

and

a

slowdown

in

growth.

3.

Controversial

Point

1:

One Can

Explain

Stagflation

within

a

Model

with

Only

Monetary

Shocks

Let

me

start

with what looks

like

a

semantic

issue,

but is in fact more.

Comment.

185

Barsky

and Kilian

define

"stagflation"

as the

coincidence

of

"low or

negative

output growth"

and

"high

inflation"

(i.e.,

Au

>

0,

7r

high). They

argue-

rightly-that

this is

easy

to

generate

in a model with nominal

rigidities.

In

effect,

we know that

inflation

builds

up

slowly after

a

monetary expansion.

At

some

point,

high

inflation

leads to a decrease in real

money,

which in

turn

leads

to a

decrease in

output

growth;

at that

point

there

is indeed

high inflation

and

low,

possibly

negative, output growth.

A

more conventional

definition of "stagflation"

however is the

coincidence

of

high unemployment

and

increasing

inflation

(i.e.,

u

high,

and AT

r

>

0.

Why

does this semantic

discussion matter?

Because

(1)

what

was ob-

served

in

the 1970s was

indeed

a

combination of

high

unemployment

and

increasing

inflation,

i.e.

stagflation

according

to the

second

defini-

tion;

(2)

this combination is

very

hard to

generate

in

response

to

only

changes

in

money growth.

Let

me

develop

both

points.

On the

empirical

evidence: The

average unemployment

rate from

1973

to

1975

was

6.4%,

substantially higher

than

what

the natural

rate of

unemployment

had been until

then.

And,

over

the same

period,

the

increase

in

inflation

was around

5

percentage points.

The

period

was

one

of

high unemployment

and

increasing

inflation.

On

the

theoretical

proposition:

Go

back

to a

conventional

Phillips-

curve

relation:

-Tt

-

-t

=

-a(u -

l).

Inflation minus

expected

inflation

is

a

decreasing

function of

the dis-

tance between

the actual

unemployment

rate and

the

natural

unemploy-

ment

rate.

In

the

absence

of

supply

shocks,

a

is

a

constant.

Stagflation

(according

to the

second

definition,

and

the

1973-1975

facts)

implies

the

coincidence of

increasing

inflation,

viz.

7Tt

-

lt_

>

0,

and of

unemployment

above

the natural

rate,

viz.

ut

-

u

>

0,

so

that,

by

implication,

'Tt

-

t

<

0.

These

two

conditions

can

be

rewritten

as

t

-

7t_t-

>

ITt-

7t-

1>

0.

186

*

BLANCHARD

In

words,

the

expected

increase

in

inflation must

exceed

the actual

in-

crease

in

inflation,

and this at

a

time at which inflation is

increasing.

It is

difficult

to think of

expectation

formation mechanisms

which

will natu-

rally

deliver this result.

The

learning

model

presented by

Barsky

and

Kilian does not.

In

general,

learning

does

not seem

promising

here:

It

seems more

likely

to

lead to the

opposite inequality,

with the

expected

increase

in inflation

lagging

behind the

actual increase.

So,

how

can one

generate stagflation? By

having

an

increase

in the

natural rate

a, or,

equivalently

for our

purposes,

a

positive

disturbance

to

the

Phillips-curve

relation.

A natural

candidate

is

an

increase

in the

price

of

oil,

which

generates

an increase

in

a, or,

equivalently

for our

purposes,

a

positive

disturbance

in the

Phillips-curve

relation.

Thus,

the

traditional

focus

on

supply

shocks

to

explain

the

1970s.

This

argument

however

suggests

one

way

out

for

proponents

of the

monetary-policy

explanation.

Barsky

and Kilian do not

push

it

explicitly,

but

clearly

they

could,

as it is

in

the

spirit

of their

paper.

If

expansionary

monetary policy

leads to

an

increase

in

the relative

price

of

oil,

then

one

indeed

can

in

principle

generate stagflation

just

from

monetary

shocks.

This leads

to the second

major

issue,

the

degree

to which one

can

think

of the

large

increases

in the

price

of oil

in the 1970s

as

endogenous

and

triggered

by

monetary policy.

4.

Controversial

Point

2:

The Increase

in the Price

of

Oil

in

the

1970s

Was

an

Endogenous

Response

to a

Money-Driven

World

Boom

Here,

theory

is on

the side

of

Barsky

and Kilian.

Oil is

a natural resource.

Current

or

anticipated

increases

in demand or

decreases

in the real

interest

rate

should

both

lead to

an

increase

in the

current

price.

And,

indeed,

the

early

1970s were

a

period

of

high

demand

and low

real

rates.

The

problem

is

empirical.

I

am

no

expert

on

the oil

market.

But

from

my

reading

of the

literature,

I

have the

strong

feeling

that most

experts

agree:

The

two

increases

in

the

price

of oil

were

not

the

natural,

if

delayed,

response

to

demand

and interest

rates,

but

were

mostly

the

result

of successful

cartelization.

Agreement

among

experts

is

surely

no

proof.

But the

hypothesis

of

endogenous

increase

in

the

price

of

oil runs

into

a number of

obvious

problems

(my-very

limited-knowledge

on these

issues

is

largely

based

on

M.

A.

Adelman's

writings,

in

particular

Adelman,

1993):

The

degree

to which

the

price of

a

good

depends

on the

interest

rate

depends

on

the

degree

to which

it

is

a

fixed

rather than

a renewable resource.

And

here,

the

Comment 187

evidence seems

to be that

oil behaves more like

the second than the

first.

The

amount

of

so-called

"proven

resources"

has

consistently

increased over

time,

despite

the

steady

extraction

of

oil

from

the

ground.

The

degree

to which the

price

depends

on

current

and

anticipated

demand

de-

pends

on the

slope

of

the

marginal-cost

curve,

relating

the cost

of

extraction to

theflow

of

extraction.

Evidence

suggests

that,

in the

1970s,

the

marginal-cost

curve was rather

flat:

that there

were a

large

number

offields

from

which oil

could be extracted

at close to the same cost

per

barrel-a

costfar

below

the

price

which

prevailed

from

1974 on.

The

increase in

prices

in the mid-1970s was

associated

with a decrease

in

production-not

what

you

would

expect

to

see

in

response

to

a

shift

in de-

mand. The issue

is taken

up by Barsky

and

Kilian,

who

provide

a

creative,

if

not

totally

convincing,

answer.

But there

is

another

empirical

problem

along

the same lines: The increase

in

prices

in

the mid-1970s

was associated

with

a

decrease

in

productionfor

the low-cost OPEC

countries,

and an increase in the

production

for

the

high-cost

non-OPEC

countries.

This is hard to

explain

without

giving

some

central role to

OPEC

in

the

story.

With the world recession

of

the

mid-1970s,

the

high-demand

conditions,

which

might

have

justified

the

high

price

of

oil

earlier,

largely

vanished.

And later on

in the

decade,

tighter monetary policy

led to much

higher

real rates. Yet

the

price

of

oil remained

high.

The

paper-and

the literature-invoke

"ratchet

effects"

(in

the

form of higher

excise

taxes,

imposed by

the

oil-producing

countries

on oil

companies);

but this

begs

the

question: Why

not invoke the

same mechanisms

for

the initial increase

in the

price of

oil?

5.

Controversial

Point 3:

The

Recession

of

the Mid-1970s

Was Due

to

a Contraction

in

Money

Here,

the

problem

is

again empirical

and

obvious. The

way

monetary

contraction is

supposed

to work is

through high

interest

rates. Nominal

interest rates increased

substantially

in 1974

and 1975. This is shown

in

Figure

1,

which

plots

short-, medium-,

and

long-term

interest

rates from

the

mid-1960s to the

early

1990s.

But

inflation increased

by

more, and,

based on forecasts of inflation at the

time,

so did

expected

inflation.

This

is shown

in

Figure

2,

which

plots

short-,

medium-,

and

long-term

real

interest

rates,

using

inflation

forecasts of the

time,

for the

same

period.

Real interest

rates were lowest

in 1974 and

1975; indeed,

in

both

years,

the short real

rate

was

negative,

the

longer

real

rates

very

close to zero.

(The

numbers are taken from

Blanchard, 1993;

the

construction of the

real rates

is

described

in

that

paper.)

Can the

monetary-contraction

story

survive

Figure

2?

Yes,

if

there is a

role for the nominal

interest

rate,

for a

given

real interest

rate.

And,

Figure

1

NOMINAL

INTEREST

RATES, SHORT, MEDIUM,

AND LONG: UNITED

STATES,

l

1966 TO 1992

15.0

-

SHORT NOMINAL

-

MEDIUM_NOMINAL

LONG

NOMINAL

Z

U

12.5

10.0

7.5\

5.0

2.5

66 68 70

72

'

74 76 78 80

'

8'2

84

86

8

90

92

t

I

I I

I

I I

Figure

2 REAL

INTEREST

RATES, SHORT,

MEDIUM,

AND LONG:

UNITED

STATES,

1966

TO

1992

10.0

SHORT_REAL

MEDIUM_REAL

LONG

REAL

7.5

5.0

2.5

^

0.0

-2.5

6 7-2.5

74I

i

7 78I I 8

8 I

I

-

6

'

68

70

72 74 76

78

80 82 84 86

88

90

92

C-)

00

\C

Q)

2

v^~~V

\^~I

190

*

BLANCHARD

based on

the

research

on the

interaction between

inflation,

taxation,

and

intermediation,

we can think of

a

number

of channels

through

which

nominal

rather than real rates

might

matter.

One

may

however

doubt

that the rather modest increase

in

nominal

rates could have been

enough

to

offset the effects

of low

real rates

and

generate

a

recession of

the size

observed

in

the mid-1970s.

The burden of

proof

is

on

the authors

on

this

one.

6. Controversial

Point 4: An Increase

in

the Price

of

Oil

Should

Have

No

Effect

on the

GDP

Deflator;

Yet

the

GDP

Deflator

Increased

Substantially

in the

Mid-1970s

The

argument

that

the

price

of

oil

should

not

affect

the

price

of

value

added-the

GDP

deflator-is

perfectly

valid as far

as it

goes,

that

is,

in

partial

equilibrium.

The

general-equilibrium

closure

offered

by

Barsky

and

Kilian,

with

fixed nominal

money

and fixed

employment,

is

not

convincing.

Once one uses

a more standard

macroeconomic

closure,

the

evidence

on

inflation

appears

quite

consistent

with

theory.

Let

me use

the standard

toy

model here.

Assume

that consumers

consume

a bundle

composed

of

a

produced

good

and

energy.

The

pro-

duced

good

is

produced

using

labor. Denote

by

Pv

the

(log) price

of

the

produced

good

(the

GDP

deflator),

by

x

the

(log)

relative

price

of

energy,

and

by

p

the

(log)

consumption

price

index

(the

CPI).

Then assume

p

=(1

-

0)

p

+

(p

+x),

pv=

,

w

=

ap

+

(1

-

a)p(-l)

+

ay,

y

=

m

-

p,

m

=bp,

b1l.

The

first

equation

states that

the

consumption price

index

is

a

weighted

average

of the

price

of

the

produced

good

and

the

price

of

energy,

with

0 as

the

share

of

energy

in

consumption.

The second

states

that

the

price

of

the

produced

good

is

equal

to the

nominal

wage

(the

constant

terms are

unimportant

here,

so

I

set

them

equal

to

zero).

The

third

equation

states

that the

consumption

wage depends

on

the

output

gap

y.

It

introduces

nominal

wage

rigidity

in the form

of a

depen-

dence

of

the

wage

on both

the current

and the

lagged

consumer

price

index.

The

fourth

equation

is

a reduced-form

aggregate

demand

equa-

tion

giving

the

demand

for

the

produced

good

as

a

function

of

real

money

balances.

The

last

equation

is

a

money

rule.

Comment 191

Solving

the model

is

straightforward.

For

simplicity,

let me

just

look

here

at the

limit

case

where

b

=

1,

so there

is full accommodation

by

the

central

bank,

and

y

remains constant

(the

difference with

Barsky

and

Kilian is that

constancy

of

output

is the

result of

monetary

accommoda-

tion,

so the nominal

money

stock

is

not

constant

but

endogenous).

In

this

case,

inflation is

given

by

Ox

Ap

=

(1

-

0) (1- a)

Apv

=

Aw

=

a

Ap

+

(1

-

a)

Ap

(-1).

Then:

An

increase

in

the

relative

price of energy

leads

to

positive

inflation,

measured

using

either the

CPI

or the GDP

deflator.

Even

if

the

share

of energy

in

consumption

is

small,

the

effect of

the relative

price

increase

on

inflation

can be

large.

(For

example, if

0

=

0.05 and

a =

0.5,

then

a 50%

increase

in the relative

price

of energy

leads to

an

increase in

inflation

of

5%.)

Inflation

measured

using

the GDP

deflator lags

inflation

measured

using

the

CPI.

This

is

very

much what

was observed

in

the mid-1970s. The mecha-

nism behind the increase

in

inflation is

straightforward.

Given

the

wage,

the

increase

in

the

price

of

oil

increases the CPI.

But

the

implied

decrease

in

consumption wages

leads

workers to ask

for

an

increase

in

nominal

wages,

which leads

in turn

to

an

increase

in

the GDP deflator. Under the

convenient

assumption

of

full

accommodation made

here,

inflation

goes

on

forever. Under the more realistic

assumption

of

partial

accommoda-

tion,

lower

output eventually puts

an

end

to

these

price

and

wage

in-

creases,

and

inflation

eventually

stops.

But

the

results

that

inflation lasts

for some

time,

it

can

be

quite large

relative

to the

shock,

and CPI infla-

tion

leads inflation

using

the

GDP

deflator

all remain.

7.

Conclusions

I

have

argued

that

money

cannot

be the

main

culprit

for

what

happened

in the

mid-1970s.

It

cannot

explain

stagflation.

The

behavior of

interest

rates does

not

fit.

And

most of the

movements

in

the

price

of

oil had

little to do with

monetary

policy.

192

*

BLINDER

Does this mean that

there are no

mysteries

left? The

answer

is

an

emphatic

no.

There is

plenty

we do not

understand about

what

hap-

pened

in

the

1970s,

and

more

generally

about the

price

of oil

and

eco-

nomic

activity.

The list of

puzzles

is well

known,

from

the

surprising

finding

by

Hamilton that

most U.S.

postwar

recessions have been

pre-

ceded

by

an

increase

in

the

price

of oil

(a

finding

which

may

turn

to

be

true once

more

in the

near

future),

to the

apparent asymmetry

between

the

effects

of

increases

and

decreases

in

the

price

of

oil,

to the

sheer size

of the two

recessions of the 1970s.

I

thank the two

authors

for

putting

the

issues

back on

the research

agenda.

REFERENCES

Adelman,

M.

(1993).

The Economics

of

Petroleum

Supply.

Cambridge,

MA: The MIT

Press.

Blanchard,

0.

(1993).

The

equity

premium.

Brookings

Papers

on Economic

Activity

2:75-138.

Comment

ALAN S. BLINDER

Princeton

University

This is

a

fascinating

paper,

one which is well

worth

reading.

It

more

than

repays

the time

you spend digesting

it. It

was

also,

obviously,

meant

to

be

a

provocative

paper,

and

I

was,

appropriately,

provoked.

In

my

book

Economic

Policy

and the

Great

Stagflation

(Blinder, 1979),

which

I

dusted off

to

prepare

this

comment,

I

considered the

monetary

(dare

I

say

"monetarist"?)

explanation

of the

episode

and

concluded

as follows:

"If

I

were forced

to

summarize

the

influence

of the

Fed

on

the Great

Stagflation,

I

guess

I would

stress

how

little

difference

it

made rather

than how

much."

Barsky

and

Kilian

reach

a

rather

different conclusion.

Why?

Was

I

so

wrong

in

1979?

Frankly,

I find

very

few errors of commission

in the

paper.

So

the

hunt

must be for errors

of omission.

The

paper

reads

a

bit

like a

selective

legal

brief

prepared

by

a

pair

of

clever

trial

lawyers.

So

I'll

try

to

add

a

few

arguments

for the defense

(of

the

conventional

wisdom)

and

point

out

that

some

of

the conclusions

that

they portray

as

contrary

to

that wis-

dom are

actually quite

well

known.

Leaving

out

many

interesting

details,

their

argument

comes

in

five

parts,

and I'll

take

each

up

in turn.

192

*

BLINDER

Does this mean that

there are no

mysteries

left? The

answer

is

an

emphatic

no.

There is

plenty

we do not

understand about

what

hap-

pened

in

the

1970s,

and

more

generally

about the

price

of oil

and

eco-

nomic

activity.

The list of

puzzles

is well

known,

from

the

surprising

finding

by

Hamilton that

most U.S.

postwar

recessions have been

pre-

ceded

by

an

increase

in

the

price

of oil

(a

finding

which

may

turn

to

be

true once

more

in the

near

future),

to the

apparent asymmetry

between

the

effects

of

increases

and

decreases

in

the

price

of

oil,

to the

sheer size

of the two

recessions of the 1970s.

I

thank the two

authors

for

putting

the

issues

back on

the research

agenda.

REFERENCES

Adelman,

M.

(1993).

The Economics

of

Petroleum

Supply.

Cambridge,

MA: The MIT

Press.

Blanchard,

0.

(1993).

The

equity

premium.

Brookings

Papers

on Economic

Activity

2:75-138.

Comment

ALAN S. BLINDER

Princeton

University

This is

a

fascinating

paper,

one which is well

worth

reading.

It

more

than

repays

the time

you spend digesting

it. It

was

also,

obviously,

meant

to

be

a

provocative

paper,

and

I

was,

appropriately,

provoked.

In

my

book

Economic

Policy

and the

Great

Stagflation

(Blinder, 1979),

which

I

dusted off

to

prepare

this

comment,

I

considered the

monetary

(dare

I

say

"monetarist"?)

explanation

of the

episode

and

concluded

as follows:

"If

I

were forced

to

summarize

the

influence

of the

Fed

on

the Great

Stagflation,

I

guess

I would

stress

how

little

difference

it

made rather

than how

much."

Barsky

and

Kilian

reach

a

rather

different conclusion.

Why?

Was

I

so

wrong

in

1979?

Frankly,

I find

very

few errors of commission

in the

paper.

So

the

hunt

must be for errors

of omission.

The

paper

reads

a

bit

like a

selective

legal

brief

prepared

by

a

pair

of

clever

trial

lawyers.

So

I'll

try

to

add

a

few

arguments

for the defense

(of

the

conventional

wisdom)

and

point

out

that

some

of

the conclusions

that

they portray

as

contrary

to

that wis-

dom are

actually quite

well

known.

Leaving

out

many

interesting

details,

their

argument

comes

in

five

parts,

and I'll

take

each

up

in turn.

Comment 193

1.

A

PURELY

MONETARIST

MODEL

OF

GO-STOP POLICY

GIVES

A

GOOD

EXPLA-

NATION

OF THE

STAGFLATIONARY

EVENTS OF

THE 1970s.

The authors

indeed demonstrate

that

they

can calibrate a

relatively

simple

model of

go-stop monetary policy

that matches the

cyclical

facts

without ever

mentioning

oil

prices.

Or

can

they?

When I

read,

in the last

paragraph

of Section

3,

of a

predicted

"output

trough

in

early

1987"

that

"closely

mirrors" the

facts,

I

wondered

what facts those were.

I never

noticed

a

1987

trough,

and neither did the

NBER

dating

committee.

Incidentally,

the model doesn't even need

the

"stop"

part

of

"go-stop"

to

generate

stagflation.

As we

have

all

known

for

years,

the

"go" part

alone is

enough.

In

a

textbook

aggregate-demand-aggregate-supply

dia-

gram,

if a

burst of

demand

growth

(it

need

not be

generated

by

money)

leads the

economy

to overshoot

its

potential

output,

the

adjustment

back

to

equilibrium

will entail

bothfalling

output

and

rising

prices.

Or,

moving

up

a

derivative

to the

Phillips-curve

diagram,

overshooting

the natural

rate

will

lead to

an

adjustment period

in

which

both

unemployment

and

inflation are

rising

at the same time.

Many

of

us have

demonstrated this

well-known conclusion

to

our

Economics

101 students-without

using

difference

equations.1

2. THERE

IS ABUNDANT EVIDENCE

IN

FAVOR OF

THE

MONETARY EXPLANATION.

It

is one

thing

to claim

that a

certain

type

of

model

can

explain

a

phenomenon;

it is

quite

another to claim

that

the

proffered explanation

is

empirically

relevant. So

Barsky

and

Kilian

marshal

a

variety

of

empiri-

cal

support

for

their

monetary explanation

of

stagflation.

But

I

am

not

entirely

convinced.

For

example, they

show

that

several bursts of

money growth

occurred

at

approximately

the

right

times to set off

go-stop

(or

just go-adjust)

cycles.

But

they

never mention the

(often

simultaneous and

offsetting)

shifts

of

velocity-the

very things

that

eventually

led

almost

all

econo-

mists and

policymakers

to abandon monetarism.

One

example

comes

in

1970 and

1971,

when

sharp

declines

in

velocity

seemed to validate

Ar-

thur Burns's

perspicacious

(or

was

it

lucky?)

prediction

that

falling

veloc-

ity

would

obviate most of the

dangers

of

rapid money

growth.

A

second

example

is the

apparent

downward shift

of the

conventional

money

demand

equation

in

1974-1976,

which

Steve Goldfeld

dubbed

"The

Case of the

Missing

Money."2

1.

See,

for

example,

W.

J.

Baumol

and A.

S. Blinder

(1999),

Economics:

Principles

and

Policy,

8th

ed.,

Harcourt,

pp.

590-591.

2.

S.

M.

Goldfeld

(1976),

The

Case of the

Missing Money, Brookings Papers

on

Economic

Activity

3:683-730.

194

*

BLINDER

I

do not

wish

to

dispute

the claim that a

go-stop

cycle

occurred

in

the

United States

in

1972-1973.

It did. But

it

seems

a

grave

omission to

forget

the

role of fiscal

policy.

This was

the infamous

period

in which

President

Nixon

opened

the federal coffers to

assist

his

1972

reelection

campaign,

and then

shut

them

abruptly

in

1973. Years

ago,

Goldfeld

and

I

constructed econometric-model-based measures

of fiscal

policy

which

show

a titanic

runup

in

fiscal stimulus

from

1969 to

a

peak

in 1971

and

then an

abrupt plunge

to

fiscal restraint

in

1973.3

Yes,

it was

an

aggregate-demand

story;

but

money growth

was

not

the

only

actor.

3. THE

BURST

OF WORLD

MONEY

GROWTH WAS LARGELY DUE TO

THE BREAK-

DOWN OF THE

BRETTON

WOODS

CONSTRAINTS ON

MONEY CREATION.

I

have no

quarrel

with

highlighting

the end of the Bretton

Woods

system

as an

explanation

for the

high money growth

rates

that

followed,

not

only

in

the

United

States

but

in

other countries.

But

think

about the

timing

for a

minute. The old

system

of

fixed

exchange

rates died not

all at

once,

but rather

in

stages

between

August

1971 and

early

1973. That

seems

a bit

early

to

account

for

rapid money

growth

in 1971 and

1972,

followed

by stagflation

starting

in

late 1973.

The Nixon reelection

campaign-to

which

his

friend

Arthur Burns contributed from

the

Fed-is

a more

convincing explanation

(or

at least

a

partner

in

crime)

for

the

United

States.

4. THE SUPPLY-SHOCK

THEORY OF

STAGFLATION

GIVES

NO REASON

TO THINK

THAT INFLATION MEASURED

BY THE

GDP

DEFLATOR

SHOULD RISE.

Barksy

and

Kilian do shoot

at

least

one hole

in the

supply-shock

theory:

It

gives

no

reason

to

think

the GDP deflator-as

opposed

to

some

index

of consumer

prices-should

rise more

rapidly

after

an

oil

shock.

Empirically,

of

course,

it

did.

This

is

a

legitimate

criticism of

the

conventional

wisdom-which

does

not,

of

course,

apply

to

analyses

that

focus

on

consumer-price

inflation.4

Their

point

is

really

much

simpler

than the

way

they

make it

in

the

paper.

Just

remember

that Y=C+I+G+X-IM

(another

thing

we teach

our

Economics

101

students),

and

you

will notice

that

IM

enters

with

a

minus

sign.

In

the

simple,

limiting

case

that

all

imported

oil is consumed

and

no real

quantities

are affected

by

an

oil

shock,

nominal

C and nominal

IM

would rise

by

identical

amounts,

leaving

nominal

GDP

and

all

real

magnitudes

unchanged.

Thus the

GDP deflator

would

be

unchanged.

3.

A.

S.

Blinder

and S.

M.

Goldfeld

(1976),

New

measures of

fiscal

and

monetary policy,

1958-1973,

American Economic

Review

66(December):780-796.

4.

This caused

me to

check

my

own

past

work.

Fortunately,

it

was all about

consumer-price

inflation.

Discussion

*

195

This,

of

course,

is a

rather

unrealistic account of the

way

our

economy

reacts

to an oil shock.

But it

does

point

out

that

we need a more

compli-

cated

theory-involving,

say,

markups

and

wage-price

interactions-to

explain why

an

oil shock boosts

the GDP deflator.

Having

said

that,

if

we

resist

the conclusion that

oil

shocks

are

inherently

stagflationary,

we

have

quite

a

few

coincidences

to

explain-as

is

clear,

e.g.,

from

the

work of

Jim

Hamilton

(cited

in

the

paper)

or

Carruth,

Hooker,

and Oswald

(1998).5

5.

THE

FACT

THAT

OIL PRICES ROSE

FIRST AND STAGFLATION

FOLLOWED LATER

IS

LARGELY

EXPLAINED BY

REVERSE CAUSATION:

IT WAS

MONETARY-INDUCED

BOOMS

THAT

PUSHED

OIL PRICES UP.

Thus do

Barsky

and

Kilian

elide

the aforementioned coincidences.

If I

may paraphrase Shakespeare,

methinks the

gentlemen

doth

protest

too

much on this

point.

The

simple

conventional

wisdom holds

that movements

in

the

price

of

oil

(which

are

purely

exogenous)

drive the

economy-or,

in a

variant,

that

oil

prices

drive

monetary policy,

which in turn

drives

the

economy.6

The

Barsky-Kilian

model,

by

contrast,

holds

that

monetary policy

drives the

economy,

which

in

turn

drives the

(now

purely

endogenous) price

of oil.

In

fact,

reasonable

people

do

not have to choose

either

of

these two

extremes.

Two-way

causation is

fine-and,

indeed,

I

think

that's where

Barsky

and Kilian

actually

come out

in

the end.

On the "oil

prices

are

endogenous"

side,

there is

surely

truth to the notion that

strong

world-

wide

macroeconomic conditions made

it

easier

for the

OPEC

cartel

to

work.

[But

didn't

Rotemberg

and

Saloner

(1986)

argue

that

cartels

break

up

in

booms?7]

But on

the "oil

prices

are

exogenous"

side,

I

think it is a

mistake to

argue

that

money growth

caused

the

Yom

Kippur

War

or the

fall of

the Shah.

Indeed,

don't

events like those

give

econometricians

their best

shot

at

cutting

the Gordian knot of

simultaneity?

Discussion

Robert

Barsky explained

that

the main aim

of the

paper

was

to cast

doubt on

the received

wisdom

that

stagflation

in

the

1970s

was

a

result

of an

aggregate

supply

shift

alone.

In

response

to

Olivier

Blanchard's

5. A.

Carruth,

M.

Hooker,

and A.

Oswald

(1998),

Input

prices

and

unemployment

equilib-

ria:

Theory

and

evidence

for

the United

States,

Review

of

Economics and

Statistics

LXXX,

pp.

621-628.

6.

See

Bernanke, Gertler,

and

Watson

(1997).

7.

I realize

that

other theorists

have

argued

that

strong

market conditions

help

cartels

hold

together.

That's

one of the nice

features of

economic

theory.

Discussion

*

195

This,

of

course,

is a

rather

unrealistic account of the

way

our

economy

reacts

to an oil shock.

But it

does

point

out

that

we need a more

compli-

cated

theory-involving,

say,

markups

and

wage-price

interactions-to

explain why

an

oil shock boosts

the GDP deflator.

Having

said

that,

if

we

resist

the conclusion that

oil

shocks

are

inherently

stagflationary,

we

have

quite

a

few

coincidences

to

explain-as

is

clear,

e.g.,

from

the

work of

Jim

Hamilton

(cited

in

the

paper)

or

Carruth,

Hooker,

and Oswald

(1998).5

5.

THE

FACT

THAT

OIL PRICES ROSE

FIRST AND STAGFLATION

FOLLOWED LATER

IS

LARGELY

EXPLAINED BY

REVERSE CAUSATION:

IT WAS

MONETARY-INDUCED

BOOMS

THAT

PUSHED

OIL PRICES UP.

Thus do

Barsky

and

Kilian

elide

the aforementioned coincidences.

If I

may paraphrase Shakespeare,

methinks the

gentlemen

doth

protest

too

much on this

point.

The

simple

conventional

wisdom holds

that movements

in

the

price

of

oil

(which

are

purely

exogenous)

drive the

economy-or,

in a

variant,

that

oil

prices

drive

monetary policy,

which in turn

drives

the

economy.6

The

Barsky-Kilian

model,

by

contrast,

holds

that

monetary policy

drives the

economy,

which

in

turn

drives the

(now

purely

endogenous) price

of oil.

In

fact,

reasonable

people

do

not have to choose

either

of

these two

extremes.

Two-way

causation is

fine-and,

indeed,

I

think

that's where

Barsky

and Kilian

actually

come out

in

the end.

On the "oil

prices

are

endogenous"

side,

there is

surely

truth to the notion that

strong

world-

wide

macroeconomic conditions made

it

easier

for the

OPEC

cartel

to

work.

[But

didn't

Rotemberg

and

Saloner

(1986)

argue

that

cartels

break

up

in

booms?7]

But on

the "oil

prices

are

exogenous"

side,

I

think it is a

mistake to

argue

that

money growth

caused

the

Yom

Kippur

War

or the

fall of

the Shah.

Indeed,

don't

events like those

give

econometricians

their best

shot

at

cutting

the Gordian knot of

simultaneity?

Discussion

Robert

Barsky explained

that

the main aim

of the

paper

was

to cast

doubt on

the received

wisdom

that

stagflation

in

the

1970s

was

a

result

of an

aggregate

supply

shift

alone.

In

response

to

Olivier

Blanchard's

5. A.

Carruth,

M.

Hooker,

and A.

Oswald

(1998),

Input

prices

and

unemployment

equilib-

ria:

Theory

and

evidence

for

the United

States,

Review

of

Economics and

Statistics

LXXX,

pp.

621-628.

6.

See

Bernanke, Gertler,

and

Watson

(1997).

7.

I realize

that

other theorists

have

argued

that

strong

market conditions

help

cartels

hold

together.

That's

one of the nice

features of

economic

theory.

196

*

DISCUSSION

discussion,

he

raised the

possibility

that,

with

sufficiently responsive

expectations

on

the

part

of the "awake"

firms,

the model

in

the

paper

might generate expected

inflation

greater

than

lagged

inflation.

On car-

tels,

he said

that the

links between interest

rates,

output,

and

cartel

power

could

go

in

both directions.

In

particular,

when

interest rates

are

low and

output

is

high,

the incentives to cheat

might

be less.

Barsky

responded

to

Alan Blinder's

discussion

by

saying

that

monetary

over-

shooting

could lead

to a

stagflation

in

the

model.

This result

depended

on

the amount

of

"sleepiness"

in

firms

and

the

endogeneity

of

monetary

policy.

He stressed

the

similarity

between their

paper

and

Bernanke,

Gertler,

and Watson

(1997),

the

main

difference

being

that their

paper

argued

that the

Fed

was

responding

to

commodity

price

inflation

alone,

rather than to

inflation

in

both

commodity

and oil

prices

as

in

BGW.

Barsky agreed

with Blinder that

Arthur

Burns

might

have loosened

money

supply

to

help

Nixon's

re-election,

but

he

noted that

commodity

price

inflation

gave

Burns the excuse

he

needed.

Mark Gertler

suggested

that,

because of

the

regulation

of

depository

institutions

in the

1970s,

increases

in nominal interest rates

could

have

had an

effect

on economic

activity

even without

increases

in real rates.

For evidence

on this

point,

he

suggested

that

the

authors

look

at

what

happened

to

housing

in 1973.

He

agreed

with Blanchard

that more than

a

purely

monetary story

was

necessary

to

explain

the combination

of low

growth

and

high

inflation

of

the

early

1970s. Gertler

noted

the

potential

role

of the

productivity

slowdown

in 1972 and the

resulting

decline

in

growth;

it

could

be

argued

that

the

Fed,

failing

to

understand

what was

happening,

eased

policy,

leading

to

high

inflation. He

put

forward

the

possibility

that the

opposite

has

happened

in

recent

years,

during

which

productivity

has

surged

and inflation

has

been

low.

Michael

Klein remarked

that

the

exchange-rate

channel

was one

way

that

a

monetary expansion

might

have fed

into

a

rise

in the dollar

price

of

oil. Charles

Engel

followed

up

on this comment

by

saying

that,

until

1990,

a dollar

depreciation

was related to

an increase

in

the

price

of

oil,

and vice

versa.

A

possible

explanation

is that

oil was

priced

in

dollars.

When the dollar

fell,

the oil

price

fell

in

Europe

and

Japan,

increasing

world demand

and the

world

price

of

oil.

This

could

be consistent

with

a

money-based

account

if

money growth

caused

the

depreciation.

The

problem

is

that

empirical

studies have

not found

a

close

connection

between

monetary policy

and

exchange-rate

changes

in the short

run.

David

Romer

agreed

with

the

general

point

made

by

the authors

that

something

more than

an oil

price

shock

was

necessary

to

explain

the

1970s.

He was

worried

by

the fact

that,

though

an

oil-price-shock

story

works

well for

the

1970s,

oil

prices

are

rarely

invoked

to

explain

the

Discussion 197

events of

the

past

20

years.

Blinder

responded

that an

oil-price

story

would work for

the 1990 recession.

Barsky

and Romer

disagreed,

saying

there

was

no

stagflation

in

1990.

Greg

Mankiw

suggested

that a benefi-

cial

oil

shock

helps

to

explain

the

economy's

behavior

in

1986. Olivier

Blanchard said

that no

doubling

of the

price

of oil had

happened

outside

the 1970s. He maintained

that the one

thing

that would

be

fatal

to

the oil

story

would be a

doubling

of the

price

of oil

with no

subsequent

reces-

sion. Blinder remarked

that 1997-1998

was characterized

by

a fall in

oil

prices,

a

boom,

and low inflation.

Ben

Bernanke noted that

in the VAR

literature

that tries to look

at

the

effect of

oil

prices

on the real

economy,

it is

hard

to

find a reliable

statistical

link

between

indicators of oil

price

shocks and

subsequent

output

movements.

But

there

would be some

inflationary

effect

that

leads to

a

policy response.

Tom

Sargent

took

up

the

point, saying

that in

a model with

vintages

of

capital,

it is

difficult

to find

large

real

effects

of

oil

prices.

David Laibson

pointed

out that

in

an

[S,s]

model

of

capital

formation,

the effects of oil

prices

would be nonlinear.

Dramatic

price

shocks

in

either

direction could

depress output through scrapping

of

capital.

This

nonlin-

earity

could

explain

why

the

increases

in

oil

prices

of the 1970s

depressed

activity,

while

falling prices

in

the

1980s had

ambiguous

effects.

Mankiw

remarked

that the issue

of

modeling

sleepy

firms was an

important

one,

as the

dynamics

of the

model are

sensitive

to how

sleepi-

ness is

modeled.

He

said

that while economists have

a

good

idea of how

to

model

awake

firms,

they

did

not

yet

have

good

models of

sleepiness.

In

response

to the

general

discussion,

Lutz Kilian reiterated the

key

point

that the

prices

of other commodities rose before the

price

of oil rose

in 1973. Oil

prices

were different

in

that

they

remained

high

while other

commodity prices

fell.

He

suggested

that the success of the cartel could

explain

why

oil

prices

remained

high.

Kilian

questioned

the

link

be-

tween events such as the Yom

Kippur

War

and the

fall

of the

Shah

of

Iran

on

the

one

hand,

and oil

prices

rises

on the

other,

on the

grounds

that

the

timing

was not

right.

He

emphasized

that

embargoes

could be en-

dogenous. Barsky

agreed, noting

that

disruptions

in

the Middle

East

don't

always

raise the

price

of

oil.

Rather,

embargoes

are

imposed

when

it is

profitable

for oil

producers

to do so.