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This abstract says it all:

Why are the 2000s so different from the 1970s? A structural interpretation of changes in the macroeconomic effects of oil prices …

In the 1970s, large increases in the price of oil were associated with sharp decreases in output and large increases in inflation.  In the 2000s, and at least until the end of 2007, even larger increases in the price of oil were associated with much milder movements in output and inflation.  Using a structural VAR approach Blanchard and Gali (2007a) argued that this has reflected in large part a change in the causal relation from the price of oil to output and inflation. In order to shed light on the possible factors behind the decrease in the macroeconomic effects of oil price shocks, we develop a new-Keynesian model, with imported oil used both in production and consumption, and we use a minimum distance estimator that minimizes, over the set of structural parameters and for each of the two samples (pre and post 1984), the distance between the empirical SVAR-based impulse response functions and those implied by the model.  Our results point to two relevant changes in the structure of the economy, which have modified the transmission mechanism of the oil shock:  vanishing wage indexation and an improvement in the
credibility of monetary policy.  The relative importance of these two structural changes depends however on how we formalize the process of expectations formation by economic agents.

So, why was the oil price shock in the 1970s different than that in the 2000s? Can you get it from reading a summary of a technical paper like this? Nope. I’m not sure I can tell you – but do you really think it had something to do with vanishing wage indexation and credibility of monetary policy? Maybe. But how about this:

The oil price “shock” in the 1970s was a result of a decrease in world oil supply. There was less stuff to go around. The oil price “shock” in the 2000s was largely a result on an increase in demand. There was more stuff to go around. So while in the 1970s, when we paid a lot more for oil and the things oil was used to produce, we had far less “stuff” to trade for the newly scarce oil. In the 2000s when we pay more for oil, we are richer, we have a lot more “stuff” to trade for oil. Or to put it another way, when oil prices rise due to a limited supply of it, we have to do more with less. When oil prices rise because more people wish to use oil relative to the past, we get to do more with more. Chinese and Indian demanders do not wake up one day and demand oil. They must first produce something of value in order to get that oil. If they increase their demand for oil by first producing goods and services others value, then the world is undeniably richer. If oil prices had risen because we blew up some wells in the Middle East, we still must make high tradeoffs at the margin to secure oil, but we don’t have all of that other good stuff produced by those would-be demanders.

Even simpler: expensive oil with less stuff < expensive oil with lots of stuff. What is so difficult to understand?

3 Responses to “Why People Hate Economics”

  1. Harry says:


  2. Sanket says:

    My macroeconomics textbook tells me the reason why oil prices were so high in the 70s is because of a coordinated price increase by OPEC.

    And in a world of properly functioning property rights, shouldn’t cartels be banned because they raise or stabilize prices against market forces, therefore mis-allocating goods from those who value it the most to those who might not value it as much?

    “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” – Adam Smith

  3. azmyth says:

    Sanket: Cartels do reduce output. However, the only way to make an action by another sovereign state illegal is to invade. Cartels are difficult to maintain and frequently fall apart on their own. As long as there is free entry into the market, entrepreneurs will be tempted to enter and compete away the excess profit. When you see long term cartel-like profit, ask yourself – “Why isn’t there entry?” Adam Smith was right to point out that businesses can be self interested and greedy, but he also demonstrated the power of competition to constrain them.

    Wintercow20: Great post. Basic supply and demand analysis is very powerful, and it is a pity that economists aren’t more fluent in it. Confusing supply and demand shocks is tragically common.

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