Oil Shocks and Aggregate Macroeconomic Behavior: The Role of Monetary Policy*

A recent paper by Bernanke, Gertler and Watson (1997) suggests that monetary policy could be used to eliminate any recessionary consequences of an oil price shock. This paper challenges that conclusion on two grounds. First, we question whether the Federal Reserve actually has the power to implement such a policy; for example, we consider it unlikely that additional money creation would have succeeded in reducing the Fed funds rate by 900 basis points relative to the values seen in 1974. Second, we point out that the size of the effect that Bernanke, Gertler and Watson attribute to oil shocks is substantially smaller than that reported by other researchers, primarily due to their choice of lag length for the VAR. We offer evidence in favor of a more traditional lag length, and show that, under this speciÞcation, even the aggressive Federal Reserve policies proposed would not have succeeded in averting a downturn.