Stagflation - Monetary Alternative

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RobertB.BarskyandLutz Kilian

UNIVERSITYOFMICHIGAN ANDNBER;ANDUNIVERSITY OFMICHIGAN,EUROPEAN CENTRALBANK,AND CEPR

Do

We

Really

Know

that

Oil

Caused

the

Great

Stagflation?

A

Monetary

Alternative

1.Introduction

Therecontinues to be considerableinterest,bothamong policymakersandinthepopular press,intheoriginsofstagflationand thepossibilityof its recurrence.The traditionalexplanationof thestagflationof the1970s foundinintermediate textbooks isan adverse shiftintheaggregatesupplycurve that lowersoutputandraisespricesonimpact.1Indeed,itishard to seeinsuchastaticframework howashiftinaggregatedemandcould have inducedanythingbut amove ofoutputandpricesinthesame direction. This fact has lent credence to thepopularviewthatexogenousoilsupplyshocksin1973-1974and 1978-1979 wereprimarilyresponsiblefortheunique experienceof the 1970sandearly1980s.Forexample,TheEconomist(November27,1999)writes:Couldthebadolddaysof inflation be about to return? Since OPECagreedtosupply-cutsinMarch,thepriceof crude oil hasjumpedto almost$26abarrel,upfromlessthan$10last Decemberanditshighestsince the Gulfwar inWehave benefited from commentsbynumerouscolleaguesatMichiganandelsewhere.WeespeciallythankSusantoBasu,BenBernanke,OlivierBlanchard,AlanBlinder,MarkGertler,JimHamilton,MilesKimball,KenRogoff,AndrePlourde,MatthewShapiro,andMarkWatson.Weacknowledgeanintellectualdebt toLarrySummers,who stimulatedourinterestintheendogeneityof oilprices.AllisonSaulogprovidedableresearchassistance.Barskyacknowledgesthegenerousfinancialsupportof the SloanFoundation.Theopin-ionsexpressedinthispaperare those of the authorsand do notnecessarilyreflectviews oftheEuropeanCentralBank.1.Forexample,AbelandBernanke1998,p.433)write that-after asharpincreasenthepriceofoil-"in the short runtheeconomyexperiencesstagflation,withboth adropinoutputandaburstininflation."

138*BARSKY& KILIAN1991.Thisnear-triplingof oilpricesevokesscarymemoriesof the 1973 oilshock,whenpricesquadrupled,and1979-80,whentheyalso almosttripled.Bothpreviousshocksresultedindouble-digitinflationandglobalreces-

sion.. ..Eveniftheimpactwillbe moremodestthistime thaninthepast,

dearoilwillstill leave some mark.Inflationwillbehigherandoutputwillbelowerthantheywould beotherwise.Academiceconomists,eventhose whomaynotfully agreewiththeprevailingview,have donelittle toqualifytheseaccountsofstagflation.Ontheonehand,the recentscholarlyliterature hasfocused on therelationshipbetweenenergypricesandeconomicactivitywithoutexplic-itly addressing stagflation(see,e.g., Hamilton,1983, 1985, 1988, 1999;RotembergandWoodford,1996).On theotherhand,someauthors(e.g.,Bohi, 1989;Bernanke,Gertler,andWatson,1997)have stressed notthe direct effects of oilpriceincreases onoutputandinflation,butpossi-ble indirect effectsarisingfrom theFederalReserve'sresponseto theinflationpresumablycausedbyoilpriceincreases.Acommonthreadinthepopular press,intextbooktreatments,andinthe academic literature is that oilpriceshocks areanessentialpartoftheexplanationofstagflation.Incontrast,inthispaperwemake the casethatthe oilpriceincreases werenotnearlyas essential apartofthecausal mechanismgeneratingthestagflationof the 1970s as is oftenthought.We discuss reasons forbeing skepticalof theimportanceofcommoditysupplyshocksingeneral,and the 1973-1974 and1979-1980oilpriceshocksinparticular,as theprimary explanationof thestagfla-tionof the 1970s.First,we show that thereweredramatic andacross-the-boardincreasesinthepricesof industrialcommoditiesintheearly1970sthatprecededthe OPEC oilpriceincreases. Thesepriceincreasesdonotappearto be related tocommodity-specific supplyshocks,butareconsistentwith aneconomicboom fueledby monetary expansion.Sec-ond,thereisreasonto doubtthatthe observedhighandpersistentinflationinthe deflatorintheearlyand late 1970s can beexplainedbythe 1973-1974and1979-1980 oilpriceshocks.Theargumentthatoilpriceshocks causedthe GreatStagflation dependson theclaimthatoilpriceshocksareinflationary. Usingasimplemodel,we showthataone-time oilpriceincreasewillincreasegross output pricemeasures suchastheCPI,but notnecessarilythepriceof valueadded,asproxiedbytheGDPdeflator.Indeed,anoilpriceincreasemaylowerthe deflator.Fur-ther,thedata showthatonlytwoofthefivemajoroilpriceshockssince1970have been followedby significant changesinthe inflationrate ofthe GDPdeflator,thoughin allcases the CPIinflation ratechangedsharplyrelative to the deflator.Althoughwecometo the same conclu-

Do WeReallyKnowhatOil Caused he GreatStagflation?139sion as Blinder(1979)that oil causedaspikeinconsumer-priceinflationduringthe two moststagflationaryepisodes,weshowthat oilpricesdonotprovideaplausible explanationofthesustainedinflation thatoc-curredinthe GDP deflator aswellas in theCPI.Ifoilpriceshocks were notthesource of the GreatStagflation,whatexplainsthestrikingcoincidenceofthemajoroilpriceincreasesinthe1970sandtheworseningofstagflation?Inthispaperweprovideevidencethatinthe 1970s the riseinoilprices-likethatinothercommodityprices-wasinsignificantmeasurearesponseto macroeconomicforces,ultimatelydrivenbymonetaryconditions. This view coheres wellwithexistingmicroeconomic theories about the effect of real-interest-ratevaria-tionandoutputmovementsonresourceprices,andchallengesthe con-ventional wisdomthatmajoroilpricechangesarelargely exogenouswithrespecttomacroeconomic variables of OECDcountries.It iscommonlyheldthatmajoroilpricemovements areultimatelydue topoliticaleventsintheMiddle East. Ouranalysissuggests that-although politicalfactorswerenotentirelyabsent fromthedecision-makingprocessof OPEC-thetwomajorOPECoilpriceincreasesinthe 1970s would have been far lesslikelyintheabsence of conducive macroeconomicconditionsresultinginexcessdemand intheoilmarket.Theprevailingview thatexogenousoilpriceshocks were theprimaryculpritsofthe GreatStagflationof the1970sgoeshandinhandwiththeperceptionthatmonetaryfactorsdonotprovideanadequate explanationofstagflation.Inthispaperwedevelopmorefullyalatentdissent totheconventionalview thatmonetaryconsiderationscannot account forthehistoricalexperienceof the 1970s.2Bruno andSachs(1985)and,toalesserextent,Blinder(1979,p.77)discussmonetaryexpansionas oneimpor-tantsource ofstagflation,but theiremphasisison theinadequacyofmoneyas anexplanationofthe bulkofstagflationandcommodity pricemovements.3 Incontrast,weshow howinastylizeddynamicmodelofthemacroeconomy stagflationmayariseendogenouslyinresponsetoasustainedmonetaryexpansioneven intheabsence ofsupplyshocks.Thedatageneratedbythemodelarebroadlyconsistent,bothqualitatively

2.References thatweidentifywith thetraditional viewincludeSamuelson(1974),Blinder(1979),andBruno andSachs(1985).Precursors of ouralternativeexplanationofstagfla-tion and itsassociation with oilpricesinclude Friedman(1975),Cagan(1979),McKinnon(1982),Houthakker(1987),andDeLong(1997).3.Forexample,Bruno andSachs(1985,p.6)stresstheinadequacyofpurelydemand-sidemodels ofstagflationandproposethatcontractionarymovements inaggregatesupply(suchasoilpriceshocks)areneededtoexplaintheslide intostagflation.Blinder(1979,pp.102,209)states thattheinflationof1973-1974wassimplynota"monetaryphenome-non." Asthe causes oftheinflationary surgeinthemid-1970s,andalsoof therecessionthatfollowed,heidentifies"specialfactors"such asfoodpriceshocksin1972-1974,theoilpriceshockin1973,andthedismantlingofpricecontrolsin1974.

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