THE OIL MARKET AND MACROECONOMIC ACTIVITY IN THE INDUSTRIALIZED COUNTRIES

Disturbances in the oil market have had a major impact on the macroeconomy of the industrialized countries during the past decade. The two OPEC price shocks, 1973 and 1979, were major contributors to the poor economic performance of most of these oil consuming countries. The unsatisfactory adjustment of the world economy in the shortrun to exogenous shocks in the oil market can be attributed to certain relationships which inhibit the required flexibility.; In the oil market, the price inelasticity of non-OPEC supply and demand for oil requires most of the shortrun adjustment to occur through changes in price rather than quantity. This inflexibility of quantity if compounded by the ability of OPEC as a cartel to successfully prevent its nominally quoted official price from declining during periods of excess supply.; A model of the shortrun price behavior of OPEC oil, which described the behavior of producers and consumers, is derived and estimated. The resultant spot price reaction function proves to be highly non-linear, and oil demand must exceed a critical level of capacity before the spot price begins to rise. This model explains the upward staircasing of nominal OPEC prices. The spot price leads the official price upward. The new official price establishes a higher floor for the spot price.; Simulations are used to study the effects of changes in the rate of economic growth in the industrialized countries and the level of OPEC capacity on the price and consumption of oil. With an estimated income elasticity of demand near unity, any moderate rate of economic growth elicits an increase in the real price of oil for a given level of capacity.; The relevant shortrun relationships between the price of oil and the economy, extracted from the literature, are estimated in a two country model representing the United States and an aggregate of the remaining major industrialized countries. Differences in structural parameters are shown to explain the assymetric effect of an oil price shock among countries. For example, in the United States nominal wage rigidity facilitates a reduced real wage as the price level increases in response to higher imported oil prices. In the foreign composite, real wage rigidity impedes a decline in real wages. As a result, the foreign composite exhibits longer periods of high inflation rates and reduced output than the United States, causing real adjustment between the two countries. This is reflected as exchange rate changes. These results mirror the historical recovery from the initial 1973 OPEC price increases.; A cycle of oil price shocks is identified. The adverse economic consequences of higher oil prices occur even in the absence on any supply disturbances in the oil market. During periods of constant nominal oil prices the real price is declining, stimulating the demand for oil. This higher level of demand eventually causes the spot price to rise, initiating a round of official OPEC price increases. These higher oil prices are unable to immediately reduce demand because of the price inelasticity. Most of the reduction in oil demand emanates from the reduced level of economic activity that accompanies the OPEC price increase. Adjustment lags in oil prices and demand yield oil prices higher than those able to sustain the initial level of economic activity. The attending price inflation erodes the real price thus repeating the cycle.; The severity and frequency of this cycle of oil crises is inversely related to the level of oil production capacity. Capacity disruptions are shown to exacerbate the severity of these shocks.