Oil price shocks and the macro economy 1

Sharp increases in the price of oil and other energy products are referred to in the literature as classical examples of negative supply shocks (e.g. Brown and Yucel 2002; and Hamilton 2005). Increases in the price of oil lead to increases in the cost of production, which in general decrease the rhythm of economic activity and increase inflation. The response of nominal wages and monetary policies can amplify the shocks. ² In an important article, Hamilton (1983) argues that nine out of ten North American recessions after World War II until the mid-1970s were preceded by sharp increases in oil prices. ³ In addition, he shows that such a correlation between oil prices and output does not represent a statistical coincidence. In particular, he finds evidence of Granger causality between oil prices and output. Periods of low growth in real GDP and high inflation are preceded by high relative international oil prices.