Who’s Afraid of a Big Bad Oil Shock?

WHEN THE U.S. INVADED Iraq in March 2003, many economists feared that the war would lead to a sharp decline in Iraqi oil production, a spike in oil prices, and a woeful U.S. economy that would follow the scripts of the oil shocks of 1973, 1978, and 1990. Real oil prices did increase, indeed more than tripled, from $20 in 2001:Q4 to $62 in 2006:Q3 (in 2007 dollars). But the ailments associated with earlier oil-price increases did not appear. Instead output grew rapidly, inflation was moderate, unemployment fell, and consumers remained reasonably happy. Macroeconomists would be out of business if there were no surprises. The business of this paper is to inquire into the explanations for the surprising oil noncrisis of the early to mid-2000s. The robustness of the economy following the latest oil shock can perhaps be seen in the context of an important historical development in macroeconomics, namely, the Great Moderation. Over the past half-century, the economy has shown declining volatility of inflation, unemployment, and output growth. Perhaps the moderated response of the economy to the latest oil shock should be understood as part of this overall decline in volatility. Although much has been written about the macroeconomic impacts of price shocks, little analysis is available on the impact of the most recent oil price shock. Most research focuses on the role of monetary policy and