Higher prices are disastrous for the economy

Ever since the 1973 energy crisis, economists have attempted to learn how oil (or energy) price disturbances affect the growth of output, employment, productivity and inflation.9 To help answer this question, economists tyypically use models to explain how the economy operates. There are numerous competing models out there, and no one model can account for every last wiggle in the data. That said, one well-known model is a standard aggregate production function framework. In this approach, an economy's output (real GDP) is determined by the quantity and quality of its capital and labor inputs.10 Thus, how fast the economy ultimately grows depends on its rate of investment (increase in capital), its population growth (increase in labor) and its productivity growth (increase in the efficiency of capital and labor arising from technological improvements). Inflation is a product of the money market: An excess supply of money—determined by monetary policy—relative to demand causes inflation to accelerate.

In this simple model, an increase in oil prices reduces the relative efficiency of older capital (machines and equipment); newer capital uses energy more efficiently. Firms react by striving to economize on their use of energy in the production process by scrapping older vintages of capital goods. Thus, capital obsolescence results in less capital available per worker, causing a reduction in labor productivity, a decline in output and an increase in the price level. Although unemployment tends to increase, the fall in the real wage may spur firms to change the mix of their inputs—substituting the relatively less expensive labor for the more expensive capital. For a decrease in oil prices, the effect is just the opposite: Productivity and output increase, while inflation subsides.

Ultimately, higher inflation results from too much money chasing too few goods. Whether higher inflation results from an increase in energy prices depends, first, on whether the increase in oil prices is temporary or permanent and, second, on whether the Federal Reserve chooses to increase the supply of money to counteract the adverse effect on output and employmnet. Economists now generally agree that the Fed was too accommodative during most of the 1970s, when the relative price of oil increased steadily. That is, it actually fueled higher inflation by increasing the supply of money too much. During the Gulf War-induced jump in oil prices, which was short-lived, the Fed was more successful, as evidenced by the subsequent deceleration in inflation and rebound in economic activity.