Understanding the Large Negative Impact of Oil Shocks

This paper o¤ers a plausible explanation for the close link between oil prices and aggregate macroeconomic performance in the 1970s. Although this link has been well documented in the empirical literature, standard economic models are not able to replicate this link when actual oil prices are used to simulate the models. In particular, standard models cannot explain the depth of the recession in 1974-75 and the strong revival in 1976-78 based on the oil price movements in that period. This paper argues that a missing multiplier-accelerator mechanism from standard models may hold the key. Keywords: Oil Prices; Real Business Cycle; Capacity Utilization; Externalities; Monopolistic Competition; Multiplier-Accelerator. JEL classi…cation: E32, E37, E22. We thank Karl Shell, Deborah Kerley, John McAdams, participants at the Cornell-Penn State Macro Conference (Fall 2004), two anonymous referees and the editor, Ken West, for helpful comments. Luís Aguiar-Conraria acknowledges …nancial support from Fundação para a Ciência e a Tecnologia, grant SFRH-BD-4982-01. The views expressed in the paper and any remaining errors are the authors’ alone. Correspondence: Yi Wen, Research Department, Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis, MO 63166. E-mail: [email protected].