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BPEA Article

Who’s Afraid of a Big Bad Oil Shock?

William D. Nordhaus


WHEN THE UNITED STATES INVADED Iraq in March 2003, many economists
feared that the war would lead to a sharp decline in Iraqi oil production,
a spike in oil prices, and a woeful U.S. economy that would follow
the scripts of the oil shocks of 1973, 1978, and 1990. Real oil prices did
increase, indeed more than tripled, from $20 in 2001:Q4 to $62 in 2006:Q3
(in 2007 dollars). But the ailments associated with earlier oil-price increases
did not appear. Instead output grew rapidly, inflation was moderate, unemployment
fell, and consumers remained reasonably happy.1
Macroeconomists would be out of business if there were no surprises.
The business of this paper is to inquire into the explanations for the surprising
oil noncrisis of the early to mid-2000s. The robustness of the economy
following the latest oil shock can perhaps be seen in the context of an
important historical development in macroeconomics, namely, the Great
Moderation. Over the past half-century, the economy has shown declining
volatility of inflation, unemployment, and output growth.2 Perhaps
the moderated response of the economy to the latest oil shock should be
understood as part of this overall decline in volatility.

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