Did Oil Price Increases Contribute Much to Stagflation?
By David Henderson
Mankiw’s Text Hints at Yes, But The Answer is No
One of the standard claims made about the 1970s is that a major contributor to inflation and low growth was OPEC. In his excellent textbook, Macroeconomics, 6th ed., for example, on pp. 274 and 275, Greg Mankiw gives a table showing changes in oil prices along with the related inflation rates and unemployment rates. Of course, he shows a connection: large increases with oil prices are associated with high inflation rates and unemployment rates. President Jimmy Carter leaned heavily on this association in claiming, while president, that OPEC was a major villain.
But how major? It’s not surprising that Carter didn’t answer this but, more surprisingly, Mankiw doesn’t either.
Take as our starting point the quantity equation, MV = Py, where M is the money supply, V is velocity, P is the price level, and y is real income. A good rough way to measure the effect on P of changes in oil prices is to look at the effect of oil prices on y, real income. In 1973-74, OPEC raised world oil prices from $3 a barrel to $11 a barrel, an increase of $8. The effect on the United States, a net importer, was to reduce U.S. real income by about $12 billion a year. This comes from multiplying 4 million barrels a day (mbd) by $8 by 365 days. (I don’t look at the effect of higher prices on U.S.-produced oil because that is a transfer from U.S. consumers to U.S. producers, not a net change in U.S. income.) That’s a one-time drop in annual real income rather than a change in the growth of real GDP. In other words, as long as the higher price persists, real GDP in a given year is approximately $12 billion lower than otherwise. At the time, U.S. GDP was about $1.4 trillion. In 1973, inflation was 6.2% and in 1974 it was 11.0%. So the increase in the price level over those two years was 1.062*1.110 – 1 = 1.18 -1 = 0.18, or 18%. Only one percentage point of the 18-percentage-point increase in the CPI can be accounted for by the OPEC price increase.
Similarly, Mankiw states that the halving of oil prices in 1986 “led to one of the lowest inflation rates in recent U.S. history and to falling unemployment.” It helped, but how much?
Again, use the same method as with the price increase. In 1986, oil prices dropped by about $10 a barrel. At the time, the U.S. was importing 5mbd. So the increase in real GDP was $10*5mbd*365 = $18 billion. In an economy with a $4 trillion GDP, this fall in prices caused a less than 0.5% increase in real GDP and, therefore, accounted for only about 0.5 percentage points of the reduced inflation. Unfortunately, Mankiw’s textbook gives a different impression on both the upside and the downside.