EMs in the oil shock

Policymakers are going into an examination hall

- AJAY SHAH

How does the world economy shape up when faced with a big energy disruption? The decade of the 1970s provides us the essential reference point. From the Yom Kippur War to the Iranian Revolution, we got an overall 12 times increase in the price of crude oil.

At the time, developed economies correctly passed on all price increases in petroleum products to the consumer. This permitted the price system to work. Consumers and firms faced the true cost of energy. This led to lower demand and higher energy efficiency. But the advanced economies operated in a muddled intellectual framework of macroeconomic policy. Policymakers attempted to manage exchange rates. Monetary policy then was not organised fundamentally around the inflation target. Central banks tried to be kind to the people, accommodating the supply shock with loose monetary policy. This worked poorly. The decade of the 1970s was a bad place for economic growth in developed markets, not solely because of the jump in the price of oil, but because macroeconomic policy failed.

‘Modern macroeconomic knowledge was built literally out of these difficult experiences. The intellectual advances of floating exchange rates, independent central banks, and inflation targeting were born of the failures of alternative ideas when faced with the oil shock. The Great Moderation, of good macroeconomic outcomes from 1984 to 2007, was created by these intellectual advances.