The effects of oil price shocks on U.S. inflation

During the 1970’s the United States experienced several periods of high inflation that have been at least partially attributed to positive oil price shocks. The effectiveness of the Organization of Petroleum Exporting Countries at controlling the price of oil has varied over time, as well as the responsiveness of U.S. inflation to an oil price shock. Current economic theory, supported by empirical data, suggest that oil price shocks can lead to short run changes in inflation. Since the GDP deflator can be considered the average price of final goods produced in an economy, the effects from an input price change can be quite different on the GDP deflator from the Consumers Price Index which measures the average price of consumption. As the price of oil rises, nominal value added falls while domestic real value added remains constant, creating a short run deflation in value added measures such as the GDP deflator. The CPI experiences rising inflation because the consumer’s goods basket has now become more expensive from the rising price of oil. In the long run, inflation is not affected by an oil price shock because it is controlled by monetary policy