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Since 1973, high and rising oil prices have seriously aggravated the management of macroeconomic policy. This report assesses the consequences of oil price rises for the general price level, employment, the trade balance, domestic and international credit markets, and the exchange rate in the United States and other major industrial countries. Based on earlier work undertaken for the Joint Economic Committee, this report was requested by the Subcommittee on Revenue Sharing, Intergovernmental Revenue Impact, and Economic Problems of the Senate Finance Committee. In accordance with CBO's mandate to provide objective and non-partisan analysis, the report makes no recommendations.

This report was prepared by Heywood Fleisig of CBO's National Security and International Affairs Division, under the general supervision of David S.C. Chu and Robert F. Hale. The author gratefully acknowledges the helpful comments of James Annable, Lawrence DeMilner, Everett Ehrlich, William Pegram, and Nancy Swope of the CBO staff ; and of Richard Bartel of Challenge Magazine, Ben Grain of the House Committee on Banking, Gina Despres of Senator Bradley's staff, Richard Freeman of the Federal Reserve Board, Lance Girton of the University of Utah, Paul Krugman of the Massachusetts Institute of Technology, Robert Lawrence of the Brookings Institution, Stephen McSpadden of the House Committee on Government Operations, Charles Pearson of the School for Advanced International Studies of The Johns Hopkins University, and Thomas D. Willett of Claremont Graduate School. The assistance of outside reviewers implies no responsibility for the final product, which rests solely with the Congressional Budget Office. Francis Pierce edited the manuscript; Jean Haggis prepared the paper for publication.
 

Alice M. Rivlin
Director
February 1981
 
 

SUMMARY

CHAPTER I. INTRODUCTION

CHAPTER II. HOW OPEC OIL PRICE INCREASES INITIALLY RAISE THE GNP DEFLATOR AND THE CONSUMER PRICE LEVEL

• Greater U.S. Energy Production Increases Oil Price Impact on U.S. GNP Deflator
• Greater U.S. Energy Consumption Increases Oil Price Impact on U.S. Consumer Price Index
• Lower U.S. Energy Taxes Increase Oil Price Impact on U.S. Consumer Price Index
• Oil Price Increases Indirectly Raise Nonenergy Prices by Increasing Input and Substitute Price
• Monetary Policy Constrains the Overall Price Increase

CHAPTER III. HOW OPEC OIL PRICE INCREASES REDUCE REAL DISPOSABLE INCOME, REAL GNP, AND EMPLOYMENT

• Policymakers Cannot Offset the Decline in Potential Real Disposable Income in Oil-Importing Countries
• Policymakers Do Not Fully Offset the Decline in Economic Activity in Oil-Importing Countries

CHAPTER IV. HOW OPEC OIL PRICE INCREASES AFFECT TRADE BALANCES WITH OIL-IMPORTING COUNTRIES

• Unable to Adjust Spending to Revenues Quickly, OPEC Runs a Current Account Surplus
• The U.S. Trade Balance Has Become More Sensitive to OPEC Price Increases
• The U.S. Trade Balance with OPEC Changes More with Income than Do the Trade Balances of Other Countries

CHAPTER V. HOW OPEC OIL PRICE INCREASES AFFECT DOMESTIC AND INTERNATIONAL CREDIT MARKETS

• Demand for Credit Increases by More Within the United States than Within Other Countries
• OPEC Members Demand Dollar-Denominated Assets to Store Their Surpluses
• Other Oil-Importing Countries Demand More Dollar-Denominated Reserves

CHAPTER VI. HOW OPEC OIL PRICE INCREASES AFFECT THE DOLLAR EXCHANGE RATE

• Why the Dollar Will Appreciate if Central Banks Do Not Change Credit Supplies
• U.S. and Foreign Central Bank Reaction May Produce a Different Dollar Exchange Rate

CHAPTER VII. POLICY PROBLEMS AND OPTIONS

• The Macroeconomic Costs of a Rising Oil Price
• The Macroeconomic Costs of a High Oil Price

APPENDIX A. MEASURING THE RELATIVE IMPACT OF OIL PRICE CHANGES ON U.S. AND FOREIGN GNP DEFLATORS AND CONSUMPTION EXPENDITURES DEFLATORS

APPENDIX B. HOW EXCHANGE RATE CHANGES AFFECT DOMESTIC OIL PRICES

APPENDIX C. HOW OIL PRICE INCREASES AFFECT REAL GNP AND REAL DISPOSABLE INCOME

APPENDIX D. DECOMPOSING THE PERCENTAGE CHANGE IN OIL IMPORTS INTO ITS COMPONENTS

APPENDIX E. EFFECT OF OIL PRICE INCREASES ON NOMINAL GNP AND NOMINAL DISPOSABLE INCOME IN THE UNITED STATES AND IN OTHER INDUSTRIAL COUNTRIES

APPENDIX F. ESTABLISHING PLAUSIBLE RANGES FOR ESTIMATES OF THE DEMAND FOR SAUDI ARABIAN OIL
 

TABLES
1.	DOMESTIC ENERGY PRODUCTION, GROSS DOMESTIC PRODUCT, AND WEIGHT IN GDP DEFLATOR IN SELECTED OECD COUNTRIES RELATIVE TO THE UNITED STATES, 1977
2.	DIRECT RESIDENTIAL ENERGY CONSUMPTION RELATIVE TO TOTAL PRIVATE CONSUMPTION EXPENDITURES IN THE UNITED STATES AND IN SELECTED FOREIGN COUNTRIES AND REGIONS, 1977
3.	RELATIVE EFFECT OF A CHANGE IN THE OIL PRICE ON THE PRICES OF GASOLINE IN SELECTED WESTERN COUNTRIES
4.	HOME CURRENCY PRICE CHANGES OF REGULAR GASOLINE IN THE UNITED STATES AND SELECTED EUROPEAN COUNTRIES
5.	DIRECT AND ESTIMATED INDIRECT WEIGHTS OF EXPENDITURES ON ENERGY CONSUMPTION IN TOTAL EXPENDITURES ON CONSUMPTION, 1967
6.	OPEC TRADE WITH THE UNITED STATES AND SELECTED REGIONS, 1973-1978
7.	EFFECTS OF A HYPOTHETICAL 100 PERCENT OPEC PRICE INCREASE ON TRADE BALANCES WITH OPEC
8.	COMPONENTS OF CHANGE IN QUANTITIES OF ENERGY IMPORTS FOR THE UNITED STATES AND SELECTED OECD COUNTRIES, 1973-1977
9.	OIL-EXPORTING COUNTRIES' HOLDINGS OF RESERVE ASSETS, DOLLAR-DENOMINATED AND OTHER, 1973-1978
10.	CURRENCY DENOMINATION OF SOME IMPORTANT LONG- AND SHORT-TERM FINANCIAL INSTRUMENTS
11.	ESTIMATED DOLLAR DENOMINATION OF OPEC RESERVE AND NONRESERVE FOREIGN ASSETS, 1974-1978
12.	NATIONAL DEBT OF MAJOR COUNTRIES, 1979
13.	TOTAL DOLLAR VALUE OF OUTSTANDING DOMESTIC PRIVATE BONDS AND STOCKS IN MAJOR WESTERN COUNTRIES, 1977
14.	CURRENCY DENOMINATION OF FOREIGN EXCHANGE RESERVES, 1973-1978
15.	PERCENTAGE CHANGE IN DOLLAR EQUIVALENT OF FOREIGN EXCHANGE RESERVES HELD BY MAJOR NATIONAL ECONOMIC GROUPING
16.	CHANGES IN UNEMPLOYMENT RATES AND CONSUMER PRICES IN THE UNITED STATES, GERMANY, AND SWITZERLAND
17.	EVOLUTION OF TRADE BALANCES, 1973-1978
C-1.	ESTIMATED PERCENTAGE DECLINE IN GNP FROM AN OPEC OIL PRICE INCREASE
F-1.	THE IMPLIED CIA FORECAST OF 1982 DEMAND FOR SAUDI ARABIAN OIL
F-2.	ESTIMATED RANGE. OF VALUES FOR THE CIA FORECAST OF 1982 DEMAND FOR SAUDI ARABIAN OIL
FIGURES
1.	COMPONENTS OF THE EXCHANGE-RATE EFFECT OF OIL-PRICE-RELATED CHANGES IN DEMAND FOR DOLLARS AND OTHER DOLLAR-DENOMINATED FINANCIAL ASSETS
2.	ILLUSTRATIVE SKETCH OF PRICE LEVEL AND UNEMPLOYMENT RATE AFTER OIL PRICE INCREASE
3.	ILLUSTRATIVE SKETCH OF INFLATION RATE AND UNEMPLOYMENT RATE AFTER OIL PRICE INCREASE

 

The high and rising price of oil burdens industrial oil-importing countries in two ways. First, it lowers the standard of living below what it would otherwise be. Second, it affects the economy in ways that are difficult for policymakers to manage: on the one hand, the rising oil price spurs general inflation; on the other, it depresses domestic demand and employment. Policymakers typically do not fully offset the effect on employment because they simultaneously try to hold down the rate of inflation.

Price levels in the United States rise more with oil price increases than do price levels in other industrial oil-importing countries. The U.S. Consumer Price Index rises more than consumer price indexes in other countries mainly because energy bulks larger in U.S. consumption. The GNP deflator, often consulted as a broader measure of price performance, also rises more in the United States than in other countries. The deflator measures the price of domestically produced output ; its increase reflects larger U.S. domestic oil production relative to total GNP--a consequence of greater U.S. energy self-sufficiency.

When they are not offset by policy actions, oil price increases will depress economic activity in oil-importing countries. The greater the share of oil in total consumption, the greater the depressing effect of an oil price rise, since the greater will be the fall in domestic demand for domestically produced goods. Larger domestic oil production relative to GNP, and increases in exports to oil-exporting countries, can offset part of these effects. But, on net, for typical major oil-importing countries today, oil price increases depress demand. Studies based on simple economic models indicate that the depressing effect of an oil price rise is somewhat greater in Japan and Europe than in the United States.

The U.S. trade balance against OPEC is more volatile than the trade balances of other industrial countries. The larger swings in the U.S. trade balance do not reflect U.S. export performance, but rather the greater responsiveness of U.S. oil imports to income changes. This greater responsiveness comes about because imports comprise a smaller part of total U.S. oil consumption. Thus, a rise in income and oil consumption will increase U.S. oil import volume by a relatively larger percentage than it will that of other major oil-importing countries.

Even though oil price increases raise the U.S. price level and trade deficit relative to those of other countries, they also initially raise the value of the dollar. The dollar appreciates because:

• The stimulus to inflation increases the domestic demand for credit and attracts foreign capital;
  
  
• OPEC members invest the proceeds of their trade surpluses in dollar-denominated assets ; and
  
  
• Other oil-importing countries increase their holdings of dollar-denominated international reserves.

The actions of the Federal Reserve probably reinforce this initial dollar appreciation. The Federal Reserve has typically pursued relatively restrictive policies immediately after oil price increases, easing up only later when unemployment rises.

The dollar does not rise permanently, though; as inflation eases, domestic credit demand and interest rates fall in U.S. credit markets. At the same time, OPEC members draw down their dollar assets to buy foreign goods. But they do not spend all of their dollar-denominated assets on imports from the United States. The drop in domestic and foreign demand for dollar assets depresses the dollar exchange rate.

Whatever the proper level of the oil price, its increase imposes a burden on industrial countries: unemployment and inflation rise in a combination that policymakers cannot fully offset. In dealing with those problems, they have several policy options. They could:

• Design a monetary policy path that minimizes the combined costs of short- and long-term unemployment and inflation produced by the oil price shock. In such a strategy, monetary policy is used to control the inflationary effects of an oil price rise; fiscal policy, to offset its demand-reducing effect;
  
  
• Coordinate national trade policies to permit: a better choice of macroeconomic policies by improving the distribution of the non-OPEC deficit;
  
  
• Use income policies and oil price controls to minimize the initial impact of the oil price rise;
  
  
• Use tax and transfer policies to maintain real disposable income in the short run;
  
  
• Improve labor market programs to offset the initial unemployment effects of the oil price rise; or
  
  
• Under some circumstances, undertake policies that would lead OPEC countries to reduce the oil price.

What lessons can the United States draw from the experience of other countries? Germany and Switzerland, on examination, provide little guidance for the United States. Their apparent achievement of low rates of inflation and unemployment rests largely on their acceptance of higher unemployment rates, relative to their own typical experience, over long periods of time; the exit of women from their labor forces; and the emigration of their foreign workers. Whether Japan provides a good lesson for the United States is less clear. The United States could not have relied as heavily as Japan on expanding its trade surplus without seriously disrupting existing trading patterns. If, as some evidence indicates, Japanese success rests on superior economic organization, the United States obviously should emulate that where possible. But to the extent that Japan's success rests on restricting imports and subsidizing exports, then the United States may have to seek other policy alternatives.

A high oil price, even when it is not increasing, imposes a burden on oil-importing countries. The OPEC oil price is a cartel price, believed by some to be far higher than the price that should be charged to ration the world's scarce energy resources into the next century. This pricing policy causes a drop in living standards among oil-importing countries of between $50 billion and $100 billion per year. Oil-importing countries cannot erase this burden simply by balancing their trade accounts.

The high OPEC price can best be reduced by raising world--not necessarily U.S.--energy production and by lowering world energy consumption so as to reduce the amount of oil that Saudi Arabia can sell at the current price. Only the Saudis are vulnerable to a shrinkage of the world oil market, and only the threat of such a market shrinkage is likely to induce them to produce quantities of oil that maintain Saudi Arabia's market share by moderating the OPEC price.

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