How did OPEC Oil Price Shock in 1973 Inflate the US Economy?

OPEC Oil Price

From the vantage point in the Federal Reserve, the OPEC oil price shock in 1973 further complicated the macroeconomic environment in the early 1970s. On October 19, 1973, the Organization of Arab Petroleum Exporting Countries (OAPEC) instituted an oil embargo on the US. The embargo ceased US oil imports and began a series of production cuts that altered the world price of oil. These cuts nearly quadrupled the price of oil to $11.65 a barrel in January 1974. In March 1974, amid disagreements within OAPEC, the embargo was officially lifted.

As Arthur Burns, the chairman of the Federal Reserve at the time explained, that the manipulation of oil prices came at the most inopportune time for the US. In the middle of 1973, the US oil industry had a lack of excess production capacity, to bring more oil to market it. Thus, when OPEC cut oil production, the American oil industry could not respond by increasing supply. These market dynamics allowed OPEC to wield a much larger influence over the price-setting mechanism.

OPEC Revenue

The devaluation of the dollar in the early 1970s was also a central factor in the price increases instituted by OPEC. Since the price of oil was quoted in dollar terms, the falling value of the dollar effectively decreased the revenues that OPEC nations were seeing from their oil. They resorted to pricing their oil in terms of gold, which had pegged gold to a price of $35, and rose to $455 by the end of the 1970s. This drastic change in the value of the dollar is an undeniably important factor in the oil price increases of the 1970s.

1973-74 Oil Crises

The 1973-74 oil crises served to further complicate the macroeconomic environment. Particularly regarding inflation caused by the OPEC oil price shock in 1973. The inflation appeared to be the result of a plethora of forces: the devaluations of the dollar in 1971 and 1973, the worldwide economic boom of 1972-73, and the extraordinary increases in oil prices. The intellectual consensus among policymakers at the time was the type of inflation arising from an increase in the prices of inputs to the economy.

In the words of an economist in May of 1971, the question is whether the monetary policy could do anything to combat a persisting residual rate of inflation? Economists have since come to understand that a central bank can influence the shocks that affect inflation. Higher oil prices, because of the widespread effect of OPEC oil price shock in 1973. They will tend to generate inflationary pressures. In the short run, these forces tend to have an inverse relationship, when one rises, the other falls.

For example, monetary policy cannot offset the inflationary effects of OPEC oil price shock in 1973 at the same time. If the central bank lowers interest rates to stimulate growth, it raises enough to choke off the inflationary effect. Ultimately, the oil crisis of 1973 as a result of many factors culminated in a perfect economic storm. The oil embargo led US policymakers to underestimate their role in the broad inflation.