The Real Price of Oil and the 1970s World Inflation

This paper shows that the effects on real income and the price level of the 1973-1974 oil price increase are quite ambiguous on both theoretical and empirical grounds. The theoretical analysis reviews standard results and extends them to analyze the steady-state equilibrium and endogenous monetary policy reaction functions. It is shown that standard models and parameter values imply trivial reductions in real income and ambiguously signed changes in the price level. It is noted, however, that other special models can rationalize empirical findings of large effects. Direct real- oil-price effects in an extended Barro-Lucas real income equation are estimated for eight countries. Although statistically significant and substantial direct effects are found for about half the countries, it is noted that these coincided with countries undergoing price decontrol during 1973- 1974. Thus price-control biases in real GNP data provide an acceptable alternative explanation for the estimated effects. Simulation experiments in an international model illustrate the wide range of real income and price level effects which are consistent with the data. Further research is proposed to narrow the range of possible effects.