How Resilient Is the Modern Economy to Energy Price Shocks?

Rajeev Dhawan and Karsten Jeske
Economic Review, Vol. 91, No. 3, 2006

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While many empirical economists claim that energy price shocks drive U.S. business cycles, economists using dynamic stochastic general equilibrium (DSGE) models believe that business cycles are caused mainly by productivity shocks.

The authors reconcile the two views by constructing a DSGE model that incorporates energy use into the production function. Calibrating the model properties to match annual U.S. data from 1970 to 2005, they undertake two different experiments. The first incorporates a negative correlation between energy prices shocks and productivity as observed before 1985, and the second, without this correlation, mimics the current period.

Their simulation confirms the findings of the econometric literature that energy price shocks reduced real output growth prior to 1985. The model simulation without the correlation explains why in 1986, when energy prices fell, there was no major increase in growth rates and, most important, why there was no recession in 2005, when energy prices rose.

The authors conclude that the modern economy, represented by the period after 1985, is very resilient to energy price increases. Price controls on energy in the 1970s, the authors argue, may have done more harm than good, and they caution that policies inhibiting the functioning of free markets could again make the economy susceptible to energy price–induced recessions.

August 2006