How do shortfalls in crude oil production caused by wars and other political events in the Middle East affect oil prices, economic growth and inflation in major industrialized countries? Lutz Kilian investigates this question in CEPR Discussion Paper No. 5404 ‘The Effects of Exogenous Oil Supply Shocks on Output and Inflation: Evidence From the G7 Countries’. He notes that public discussion of this question has been shaped by the economic experience of the 1970s and early 1980s. The public’s collective memory of these experiences leaves little doubt that oil supply shocks are to blame for the economic malaise of the 1970s. This has led to the concern that history might repeat itself if a new oil supply shock were to occur.
It is not clear whether that public perception is correct, however. Lutz Kilian argues that, by any measure, a substantial component of the observed movements in the price of crude oil reflect shifts in demand for oil driven by macroeconomic conditions. Thus one cannot simply assume that major oil price increases are necessarily driven by events such as wars and political conflicts in the Middle East. Kilian proposes an alternative direct measure of exogenous oil production shortfalls based on plausible assumptions about how OPEC oil production would have evolved without political turmoil in the Middle East. Exogenous here means that the shock to crude oil production is driven by political forces in oil-producing countries that evolve indpendently of the state of the global economy.
Using this measure he has a fresh look at the historical experience of the G7 countries during previous oil supply shocks. His analysis produces the following findings:
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