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Trade Deficits Aren’t as Bad as You Think
BY GEORGE ALESSANDRIA

A

lthough the amount of U.S. imports and
exports has varied greatly over time, in recent
years, the U.S. has been running trade deficits.
Some people react to such trade deficits with
doom and gloom; others cite them as evidence that foreign
governments are not playing fair in U.S. markets; still
others argue that deficits demonstrate that we are living
beyond our means. In this article, George Alessandria
offers an alternative view: Trade deficits have benefits.
They shift worldwide production to its most productive
locations, and they allow individuals to smooth out their
consumption over the business cycle.

We live in a global world. Americans drive automobiles produced in
Germany and drink Italian wine. Europeans watch movies of Jedi Knights
battling the Dark Side on televisions
produced in Mexico. This was not always the case.
For instance, the value of U.S. imports of goods and services has grown
from 5.1 percent of gross domestic
product (GDP) in 1969 to 15.2 percent

George Alessandria
is a senior
economist in
the Research
Department of
the Philadelphia
Fed. This article
is available free
of charge at www.
philadelphiafed.org/econ/br/index.html.
www.philadelphiafed.org

of GDP in 2004. Likewise, the value
of U.S. exports of goods and services
has grown from 5.3 percent of GDP in
1969 to 10.0 percent of GDP in 2004.
The amount of U.S imports and
exports has also varied quite a lot over
time. At times, the U.S. has run trade
surpluses, with exports exceeding
imports, and at other times, it has run
trade deficits, with imports exceeding
exports. Recently, though, the U.S. has
imported a lot more goods and services
from abroad than it has exported to
the rest of the world. In 2004, this resulted in the U.S. running a trade deficit of 5.2 percent of GDP. Through the
third quarter of 2005, the trade deficit
has averaged 5.7 percent of GDP.
Some people react to the trade
deficit with doom and gloom. They
argue that the trade deficit is evidence
that American firms are unproductive

and can’t compete with foreign firms.
Others point to it as clear evidence
that foreign governments are not playing fair in U.S. markets. Still others
argue that it demonstrates that we are
living beyond our means.
But there is an alternative view. In
this view, these unbalanced trade flows
have two benefits: They shift worldwide production to its most productive
location, and they allow individuals to
smooth out their consumption over the
business cycle. According to this view,
the trade balance declines, or moves
into deficit, when a country’s firms or
government is investing in physical
capital to take advantage of productive
opportunities. These investments expand the infrastructure, build capacity
to access natural resources, and take
advantage of new technologies. This
increase in investment is financed in
part by borrowing in international
financial markets. By borrowing internationally, a country can invest more
without cutting current consumption.
When it repays this borrowing in the
future, the trade balance increases or
goes into surplus. In this respect, a
trade deficit may be a sign of a growing and robust economy. Moreover,
by increasing a country’s productive
capacity, these unbalanced trade flows
are vital to sustaining the economy’s
expansion into the future. This view is
consistent with some properties of the
trade balance in the U.S. and other
countries.
MEASURING INTERNATIONAL
TRANSACTIONS
Before discussing the reasons that
a country runs a trade deficit or surplus, it’s useful to review the different
Business Review Q1 2007 1

measures of a country’s international
transactions. These are recorded in the
balance of payment accounts (Table
1). The two main components of the
balance of payments are the current
account and the capital and financial
account. The current account records
the value of currently produced goods
and services, both imported and exported, as well as the international
payment of interest, dividends, wages,
and transfers. The capital and financial account records transactions in
real and financial assets.1
The easiest way to understand
the components of the balance of
payments is to think of a monthly
credit card statement. One part of
the statement reports the difference
between new charges and payments.
This difference corresponds to the
current account. The second part of
the statement shows the change in the
balance on the account. This measures
the amount of new borrowing from the
credit card company and corresponds
to the capital and financial account.
By definition, any unpaid portion of the bill adds one-for-one to the
balance. Similarly, a current account
deficit generates a capital and financial
account surplus of equal magnitude.
When a country is spending more
than it earns, it is also selling assets to
foreigners.
The left half of Table 1 summarizes the different components of the
U.S.’s $668 billion current account
deficit in 2004. From this we see that

1
In the balance of payments accounts, the purchase and sale of assets by central banks, such
as the Federal Reserve in the U.S., are often
measured separately in the official settlements
balance. To simplify the presentation, we have
included these transactions in the capital and
financial account. In 2004, net purchases by
foreign central banks equaled $392 billion, or
59 percent, of the capital and financial account.
For more information on the official settlements
balance, see the Survey of Current Business,
Bureau of Economic Analysis, July 2005.

2 Q1 2007 Business Review

TABLE 1
U.S. Balance of Payments, 2004*
(Billions of Dollars)
Current Account
Net Exports
Net Income Receipts
Net Unilateral Transfers

Current Account Balance

Capital and Financial Account
-617.5
30.4
-80.9

-668

Capital Account
Financial Account
Statistical Discrepancy
Capital and
Financial Account Balance

-1.6
584.6
85.1

668

*Data are from the Bureau of Economic Analysis’ Balance of Payments
Accounts. Details may not add to totals because of rounding. For more details,
see the July issue of the Bureau of Economic Analysis’ Survey of Current
Business.

the trade balance, which is the difference between the value of exports and
the value of imports, was the largest
determinant of the current account
deficit. But there are two additional,
smaller components: net unilateral
transfers and net income from abroad.
Net unilateral transfers measure the
value of gifts, foreign aid, and nonmilitary grants. Net foreign income
measures the difference of income
payments to American capital and
workers employed overseas and income
payments to foreign capital and workers employed here.2 For the U.S., net
2
A growing and serious concern about measuring the current account is how we treat capital
gains and losses on cross-border asset holdings.
Economists Pierre-Olivier Gourinchas and
Helene Rey construct a measure of the current
account with this adjustment and show that
current account fluctuations are substantially
smaller. In fact, recently, those periods in which
the U.S. has run large trade deficits also tended
to be those periods in which American asset
holdings overseas made large capital gains relative to foreign assets in the U.S.

foreign income mostly depends on the
difference in capital income — that
is, the difference between interest
and profit payments to Americans on
overseas investments and interest and
profit payments to foreigners from investments in the U.S.
To finance its current account
deficit, the U.S. ran a capital and
financial account surplus of $668 billion. Foreign purchases of U.S. assets
exceeded U.S. purchases of foreign
assets by $668 billion. These foreign
purchases of American assets funneled
foreign savings toward the U.S. Thus, a
current account deficit represents periods when foreign savings are flowing
into a country.
This brings us to another way of
measuring the current account: as the
difference between a country’s savings and investment. Savings is the
difference between what a country
produces, measured as GDP, and what
is consumed privately and by the gov-

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ernment.3 When investment exceeds
savings, a country finances this gap by
borrowing from abroad.
Since 1929, the current account
and the trade balance have been
nearly identical. The average difference is 0.02 percent of GDP. There
have been some large differences of up
to 1 percent of GDP, but these have
generally been short-lived. This may
not continue to be the case. If the U.S.
continues to run large current account
deficits and to borrow from the rest of
the world, the stock of foreign assets in
the U.S. will grow relative to the stock
of U.S. assets overseas. The payments
on this debt can lead to deficits in the
future, just as a high credit card balance today means more interest payments in the future.
For now, though, we will consider
the current account and the trade balance interchangeably, partly because,
as we have seen, historically they have
not differed by much.

individuals:4 When these individuals collectively spend more than they
earn, they finance the difference by either selling assets or borrowing. However, I might go to my neighbor (indirectly through a bank or credit card)
to borrow the amount by which my
purchases exceed my income. When a
country’s purchases exceed its income,
it pays for the difference by borrowing from its trading partners. Thus, a

her income is low again, and she lives
off the income from her savings.
This borrowing and lending over
her lifetime reflects intertemporal
trade. She has traded part of her income stream when she is working for
some payments when she is young and
some payments when she is old. This
intertemporal trade can involve long
periods of borrowing and long periods
of saving.5 This borrowing and lending

International financial markets allow countries
to borrow and lend over time through the
purchase and sale of financial assets.

INTRODUCING
INTERTEMPORAL TRADE
Just as an increase in the balance on a credit card bill involves new
borrowing from the credit card company, when foreigners buy U.S. assets,
Americans are borrowing from the
rest of the world. This international
borrowing and lending is based on the
concept of intertemporal trade. The
notion of intertemporal trade is based
on the idea that people’s purchases and
income may not always match up over
time. When this occurs, people use financial markets to borrow and save to
make up the difference between what
they buy and what they earn.
Countries are just a collection of

country can have a trade deficit either
because it is borrowing or because it
has made some loans in the past for
which it is currently being repaid.
A useful way to think about intertemporal trade is to consider the
life cycle of a typical doctor. When
she is young, she does not have many
skills. Rather than work at a low-wage
job, she goes to college and then on to
medical school, followed by an internship and residency. Before starting to
work, she has little to no income, so
she must borrow to pay for school and
her living expenses. While in school,
she is investing in accumulating skills.
These skills raise the wage she can
command once she is working. In this
case, she borrows when she is young
and invests in education. Once out of
school, she can repay these loans and
start accumulating savings for retirement. Through financial markets she
lends her savings to finance other people’s investments. Once she has retired,

is efficient, since it allows a person to
enter a profession, such as medicine,
that makes the best use of her abilities.
International financial markets allow countries to borrow and lend over
time through the purchase and sale
of financial assets. Just as the doctor
benefits from intertemporal trade, international financial markets generate
similar benefits. Let’s consider two important reasons why countries borrow
and lend over time.
International Production Shifting. The basis of the idea of international production shifting is the notion
that you want to make hay while the
sun shines. That is, when good productive opportunities present themselves,
people can take advantage of them by
investing and working more.
Over time, the productive opportunities in a country change. New
opportunities present themselves and
old ones close. Some industries make
technological advances, while others

3

4

5
Strictly speaking, when our doctor borrows to
finance her education and expenditures, she is
selling a financial asset with a claim against her
future income. Lenders carry these assets as a
credit on their balance sheets.

For those familiar with national income and
product accounts, this is the familiar relationship: Trade Balance =Savings-Investment,
where Savings = GDP-Private ConsumptionGovernment Consumption.

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Countries are composed of individuals, firms,
and governments. However, individuals own
firms and governments are made up of people.
So, for simplicity, we view countries as a collection of individuals.

Business Review Q1 2007 3

become obsolete. Some of these opportunities are small, and others are large.
To take advantage of these opportunities, firms need to hire workers and
invest in new equipment, structures,
and software.
Norway provides a clear example
of one of these productive opportunities. In the 1960s, rich petroleum
deposits were discovered in the North
Sea. Norway was one of the major beneficiaries of this discovery. Getting to
these valuable oil and gas deposits required large and repeated investments
in infrastructure, such as off-shore oil
platforms, transport pipelines, ships,
and helicopters. Norway also needed
to develop a knowledge of exploration
and extraction to precisely locate and
exploit these resources. At the time of
these discoveries, Norway lacked the
equipment and expertise to take advantage of the opportunity. To do so, it
borrowed from the rest of the world.
Because of the time involved in
building infrastructure, oil production
did not start in earnest until the mid1970s. Although the oil revenue would
eventually pay for them, the investments had to be paid for in advance.
Norway financed these investments
by borrowing from abroad (Figure 1).
From the figure, we can see Norwegian
investment grew substantially from
1969 to 1977, financed in part by a
series of almost continual trade deficits
from 1969 to 1977.
Once the oil came online, Norway began running persistent trade
surpluses, which were used to repay
its original borrowing and to save for
the day when the petroleum reserves
are exhausted. We can see that, since
1978, Norway has annually run trade
surpluses that average 6 percent of
GDP. There have been some fluctuations in the size of these trade surpluses because of changes in the price of
oil and the Norwegian business cycle.
(See The Terms of Trade and A Theory

4 Q1 2007 Business Review

FIGURE 1
Norwegian Investment and Trade Balance
Percent of GDP
40.0
Investment
30.0

20.0

10.0

0.0
Trade Balance
-10.0
1968

1973

1978

1983

1988

1993

1998

2003

*Data are from Statistics Norway.

of International Business Cycles, for a
further discussion of these two forms
of trade-balance fluctuations.)
The Norway story is an example
of a large productive opportunity, but
there are also smaller changes in productivity that may be important over
the business cycle. For instance, in the
1990s, the information technology and
telecommunication sectors in the U.S.
developed many new technologies.
These productive opportunities
affect both the private and public sectors. For instance, in Norway, the state
had sovereignty over the exploration
and production of sub-sea natural
resources, and much of the development was done within state-owned
enterprises. To take advantage of productive opportunities, firms and governments need to invest in machines
and infrastructure. This can be done
by borrowing capital from the rest of
the world. Foreign investors are happy

to make these loans, even if it means
less investment in the investors’ own
countries, because the capital is more
productive overseas and thus earns a
higher return.6 This increase in investment increases the productive capacity
of an economy in subsequent periods
and keeps the economy going strong
into the future.
Smoothing Consumption. Another important idea for understanding
the dynamics of the current account
is consumption smoothing: the notion
that people would prefer a relatively
stable consumption pattern to a variable one.

6

Some international lending is done by foreign
governments. In the case of the U.S., recently
these foreign investments have tended to be
in relatively low-interest bearing, highly liquid
assets. Arguably, the liquidity these investments
provide is highly valued by foreign governments
and compensates for the relatively low returns.

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The Terms of Trade

T

here is another important determinant
that these variables tend to move in opposite direcof the trade balance: the terms of trade.
tions. In particular, notice that the large increases in
This is the price of imports relative to the
oil prices in 1973 and 1979 were associated with large
price of exports.
decreases in the trade balance. More recently, the risOver time, the terms of trade may
ing price of oil has contributed to the worsening trade
vary because the cost of producing imports or exports
balance.*
changes or the demand for these goods changes. Quite
If we return to the case of Norway, which is a
often, we see that when the terms of trade worsen, so
large exporter of oil, we see that changes in the price
that imports become more expensive, the trade balance
of oil affect its trade balance in the exact opposite way.
declines. This often occurs because, despite the relatively
From Figure 1 in the text, we can see that Norway’s
high price of imports, we do not cut back much on our
trade balance has increased substantially along with
purchase of these imports. If we hold quantities roughly
the increase in oil prices since 1998. Similarly, the big
constant, and the terms of trade increase, the trade baldrop in Norway’s trade balance in 1985 coincided with
ance will decrease. This has been an important source of
a drop in the price of oil.
fluctuations in the trade balance over time.
More generally, the terms of trade can matter for
Oil is one good that the U.S imports a lot of, and the
other goods, such as certain industrial supplies, agridemand for oil is fairly slow to respond to price changes.
cultural products, and capital equipment, for which
This slow response occurs in part because oil is an imdemand is relatively insensitive to changes in price in
portant input into production in industries such as transthe short run.
portation and energy and there are few substitutes for
oil. These industries have made large investments in air* David Backus and Mario Crucini have shown that the market
planes, trucks, and power plants whose energy efficiency
for oil can help to explain some of the behavior of the U.S. trade
balance in the 1970s and 1980s.
is largely fixed.
Therefore, just as it is
costly for the owner of a gasFIGURE
guzzling SUV to sell that
car and buy a smaller, more
U.S. Oil Trade Balance and Oil Terms of Trade
energy-efficient car, it is difOil trade balance as share of GDP
ficult for an industry to change
Oil terms of trade
(percent)
its use of oil in the short run.
0.0
600
Thus, an increase in the price
Oil Trade Balance
of oil tends to raise the value
-0.5
500
of imports almost one-for-one
and lowers the trade balance
-1.0
400
by the same amount in the
short run. In the long run,
-1.5
300
after firms and individuals
-2.0
invest in new, energy-efficient
200
technologies, the demand
-2.5
for oil declines, so imports
Oil Terms of Trade
decline and the trade balance
100
-3.0
increases.
The figure bears this out.
-3.5
0
1967-I
1970-I
1973-I
1976-I
1979-I
1982-I
1985-I
1988-I
1991-I
1994-I
1997-I
2000-I
2003-I
It shows the trade balance in
petroleum and the price of
petroleum imports deflated by
* Data are from the Bureau of Economic Analysis.
the price of exports. Notice

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Business Review Q1 2007 5

A Theory of International Business Cycles

E

conomists David Backus, Patrick Kehoe, and Nobel Prize
recipient Finn Kydland have shown that an international realbusiness-cycle model can account for the properties of business
cycles in the G7 countries.* This is a model that includes both
consumption smoothing and production shifting.
In their view, the efficiency with which countries use capital and labor
varies over time. These changes in productivity are generally not synchronized
across countries, so that productivity may differ internationally. When there are
productivity differences across countries, it makes sense to reduce investment
in those countries where productivity is relatively low while increasing
investment in the country where productivity is relatively high.
Initially, this requires the trade balance of the high productivity country to
decline. This effectively shifts production to the more productive location. The
larger the differences in international productivity, the greater the incentives to
shift production toward the more productive countries and the larger the trade
deficit.
Because investment raises a country’s stock of capital, these capital flows
tend to raise future output and lead to sustained increases in output. Foreign
investors are happy to make these loans because they can get a better return
by lending to firms in the country with more productive opportunities. Notice
that by borrowing from abroad, the more productive country does not have to
sacrifice consumption to invest in these opportunities, allowing it to keep its
consumption smoother.
Economist Martin Boileau has shown that the effect of production shifting
is particularly important, since a large part of trade consists of capital and
durable goods, such as industrial machines, aircraft, and automobiles. Thus,
periods when investment is high are also periods in which imports will tend to
be high. Moreover, if investment is low in the rest of the world, a country will
tend to run a trade deficit.

* For a primer on the real-business-cycle view of the macroeconomy, see the article by Satyajit
Chatterjee.

tion in income to achieve a smooth
pattern of consumption.
Now imagine we restrict households to borrowing and lending from
households in the same country. To
smooth out consumption, we need to
find someone from the same country
willing to lend $25,000 in the first
year and be repaid in the second year.
Financial markets do this for us. They
channel savings from those households
with temporarily high incomes to
those households with temporarily low
incomes. This lets us smooth out the
household-specific fluctuations in individual income.
But what happens when everyone
in the same country experiences the
same shock to their income, as in a recession? For instance, suppose average
income in a country is $50,000 in year
1 and $100,000 in year 2. If we restrict
borrowing and lending with foreign
countries, consumption will vary along
with income. If we allow international
borrowing and lending, consumption
smoothing will lead to a $25,000 current account deficit in year 1 and a
$25,000 current account surplus in
year 2. So countries can use international financial markets to smooth out
countrywide fluctuations in income,
such as those that occur over the business cycle.7
With these ideas in mind, let’s
take a look at the U.S. current account
over time.

7

A simple example should make
this clear. Suppose you could choose
between consuming $50,000 this year
and $100,000 the following year or
consuming $75,000 each year for the
next two years. Most people would prefer the second plan, that is, a smooth
pattern of consumption.
Now, suppose your income varies,
as in the first plan. These types of in-

6 Q1 2007 Business Review

come variations tend to occur because
some workers receive bonuses and others may temporarily lose their jobs. If
households can’t save or borrow, their
consumption will follow their income
and will vary over time. Suppose one
can borrow at a zero interest rate.
Then by borrowing $25,000 in the first
year and repaying it in the second year,
a household can even out this varia-

Similarly, fluctuations in government expenditures can be smoothed out by borrowing
internationally. When government expenditures
exceed tax revenue, the resulting government
fiscal deficit is financed by borrowing. Whether
this borrowing results in a current account deficit depends on the private savings response of a
country’s citizens. It is often claimed that fiscal
deficits go hand-in-hand with trade deficits.
For the U.S., there are certainly periods with
these twin deficits, but there are also periods
of government surpluses and trade deficits. See
the article by Michele Cavallo for a summary
of the links between fiscal and current account
deficits.

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A LONG-TERM VIEW OF THE
U.S. CURRENT ACCOUNT
It’s not possible to describe in
detail all the ups and downs of the
current account, so let’s focus on some
particular periods and events that are
important in U.S. history (Figure 2).8
First, let’s consider the secondhalf of the 19th century. In this period,
the U.S. was still a relatively small
economy that was poised for major
economic expansion. The country experienced substantial immigration, and
there was a great migration westward.
The American railroad network was
built, and municipalities invested in
infrastructure such as ports, roads, and
municipal sewage.9 During this period,
the U.S. ran current account deficits
each year from 1862 to 1876 and 1882
to 1896. Over these two periods, the
average annual current account deficit was 1.5 percent of GDP. Investors
in London invested heavily in these
enterprises, since the returns to these
projects exceeded those to be found in
England.10 These trade deficits helped
finance the American economic expansion and were followed by a long
period of current account surpluses.
Second, let’s consider the periods
around the two world wars, during
which the U.S. ran large and persistent
current account surpluses. From 1915
to 1921, the U.S. annually ran current
account surpluses, on average, of 4.1
percent of GDP. These loans financed
both the war effort of its allies as well

8
The U.S. GDP data from 1860 to 1869 are only
an approximation, assuming a 2 percent annual
growth rate.
9
From the conclusion of the American Civil
War, the American railroad system expanded
from 35,021 miles in 1865 to 74,096 miles in
1875 and 128,320 miles in 1885. (Statistical Abstract of the United States: Bicentennial edition,
1975)
10
See the book by Kevin O’Rourke and Jeffrey
Williamson, p. 211.

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FIGURE 2
U.S. Current Account
Percent of GDP
8.0
6.0
4.0
2.0
0.0
-2.0
-4.0
-6.0
1860

1880

1900

1920

1940

1960

1980

2000

*The U.S. current account is constructed from multiple sources. The period from 1929 is based
on data from the Bureau of Economic Analysis. The data from 1869 to 1929 are from the study by
Maurice Obstfeld and Matthew Jones. The current account data from 1860 to 1869 are also from
Obstfeld and Jones. The U.S. data from 1860 to 1869 are only an approximation.

as their subsequent postwar reconstruction.
The dynamics of the U.S. current account around World War II are
similar to those in the period around
World War I. In the buildup to the
second world war and before the U.S.
entered the war, from 1938 to 1941,
the U.S. ran annual current account
surpluses of 1.3 percent of GDP. Much
of this lending financed the United
Kingdom’s war effort. From the U.S.
perspective, this was a very good investment. Once the U.S. entered the
war, it financed its war effort in part
by borrowing from its trading partners.
Thus, from 1942 to 1945, the U.S. ran
small current account deficits.
Following World War II, the U.S.
ran some very large trade surpluses
from 1946 to 1949. A large amount
of both lending and foreign aid was
directed toward Europe and Japan to
help them rebuild. Given the lack of
productive capital in place in these

countries and their relatively highly
skilled work forces, the goods from
the U.S. were effectively used to build
up the productive capacity of these
countries. These surpluses were very
important for rebuilding the European
nations and Japan following WWII.
Finally, a careful eye may notice
that the behavior of the current account since 1980 appears to have a lot
in common with the period from 1860
to 1914. In both periods, there are
large, sustained swings in the current
account. In contrast, in the interwar
and postwar periods, fluctuations tended to be small and tended toward balanced trade. These differences across
eras are a sign of the uneven progress
toward the current world of unrestricted capital flows across borders.
International financial flows were
much greater in the period before
World War I because there were very
few restrictions on them. Following
WWI, a number of restrictions were

Business Review Q1 2007 7

placed on the mobility of international capital, and they were further
increased during the Great Depression
(1929 to 1939). The postwar financial
system maintained these restrictions,
which were only gradually loosened in
the 1970s. Thus, while today’s current
account deficits are quite large, the
comparison with the postwar period,
when capital flows were partially restricted, exaggerates their magnitude.
COMMON FEATURES OF
RECENT TRADE DYNAMICS
ACROSS COUNTRIES
Over long periods of American
history, we’ve seen that production
shifting and consumption smoothing
have mattered for the trade balance.
Now, we want to see if the same is true
over the business cycle and for other
countries. We can do this by studying
how the trade balance and other key
measures of economic activity vary
over time for a group of industrialized
countries.
First, we can look at some properties of the trade balance, output, consumption, and investment for the G7
countries11 in the period 1980 to 2002
(Table 2).12 From the table we see that
certain features of the business cycle

11

The Group of 7 is a coalition of the major
industrial nations: Canada, France, Germany,
Italy, Japan, the United Kingdom, and the
United States.

12

Nobel laureate Robert Lucas has argued that
business cycles can be thought of as deviations
from a trend around which variables tend to
move together. Thus, we want to focus on the
medium-term fluctuations in economic activity.
These are the fluctuations that last from a year
and a half to eight years. We don’t think of very
short-run changes in the economic environment, such as those due to really bad weather,
as being part of the business cycle. We also don’t
think of the really long-term changes in the
economy, such as those arising from increased
female participation in the labor force, as being
part of the business cycle. These are more related to the trend component of the economy. All
of the statistics reported in Table 2 are based on
these medium-term fluctuations.

8 Q1 2007 Business Review

are quite similar across countries.13
From the first two columns, we see
that fluctuations in consumption are
generally smaller than fluctuations in
output, while fluctuations in investment are much larger than fluctuations in output. The second common
feature is that both consumption
and investment are highly correlated
with output. What this means is that
when output is growing fast, as in an
economic expansion, both investment

A CONTRARIAN VIEW OF THE
TRADE DEFICIT
The view developed here is that
the trade balance reflects the optimal
response of individuals, firms, investors, and governments to changes in
productive opportunities and needs
throughout the world. However, an
alternative view argues that trade
deficits may result from individuals borrowing to spend beyond their
means. For instance, individuals may

The trade balance reflects the optimal
response of individuals, firms, investors,
and governments to changes in productive
opportunities and needs throughout the world.
and consumption are also growing.
Since investment is more volatile than
output, investment grows much faster
than output. From our earlier accounting, this implies that the trade balance
should be declining. In fact, from the
fifth column we see that trade balances are negatively correlated with
output, so that during economic
expansions a country’s trade balance
tends to decline.
If we put these facts together, a
common picture of business cycles
emerges. When countries are expanding, they tend to be investing quite a
bit. Some of the extra production not
consumed is invested, but a lot of the
resources for investment come from
outside the country, so the country
runs a trade deficit. Borrowing abroad
to increase investment contributes to
future increases in GDP without requiring cuts in current consumption.

13
Economists David Backus and Patrick Kehoe
find similar properties of the data for a broader
group of countries over different periods.

not fully take into account the size
of their future expenditures, such as
those from government-sponsored oldage and medical benefit programs, and
not save enough today. Proponents of
this “overspending” view argue that
closing the current U.S. trade deficit
will require some policy actions to increase savings in the U.S. Absent these
policy changes, researchers expect that
closing the trade deficit may involve
some dramatic events. For instance,
economists Maurice Obstfeld and
Kenneth Rogoff argue that restoring
trade balance will require a large depreciation of the U.S. dollar. Similarly,
economists Nouriel Roubini and Brad
Setser have argued that financing the
international debt incurred following these persistent trade deficits will
require an increase in interest rates
that will discourage investment and
economic growth.
The properties of the trade balance, evident over the last almost
century and a half in the U.S. as well
as over the business cycle among industrialized countries, provide ample

www.philadelphiafed.org

TABLE 2
Business Cycle Statistics*
Standard deviation relative to GDP
Consumption

Investment

Correlation with GDP
Consumption

Investment

Trade Balance

Canada

0.80

2.84

0.88

0.70

-0.15

France

0.92

3.14

0.74

0.89

-0.43

Germany

0.88

2.32

0.66

0.78

-0.16

Italy

1.32

3.28

0.66

0.76

-0.37

Japan

0.67

2.54

0.64

0.91

-0.48

United Kingdom

1.17

3.34

0.86

0.74

-0.52

United States

0.75

2.75

0.85

0.94

-0.52

Mean - G7

0.93

2.89

0.75

0.82

-0.38

* Consumption, investment, GDP, and trade data are from the OECD's Quarterly National Accounts data set, from 1980:Q1 to 2002:Q2. The
Hodrick-Prescott filter was used to remove the long-term trends in each data series.

evidence of substantial production
shifting and consumption smoothing
and cast doubt on this overspending
view.
SUMMARY
The current U.S. trade deficit appears unusually large when compared
with that in the postwar period. But
in the postwar period, the mobility
of capital was fairly limited. In com-

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parison to an earlier era of fairly free
mobility of international capital, the
current U.S. trade deficits don’t look so
unusual.
Trade deficits tend to be a sign
of good things to come. Countries
tend to run trade deficits when they
are borrowing to finance productive
investment opportunities. This is a
way to shift world production toward
more productive locations. This inter-

national borrowing and lending has
played a prominent role in some of the
most significant events in U.S. history
— from the western expansion after
the Civil War to the financing of the
two world wars. Over the business
cycle, we also see that trade deficits are
often associated with strong and continued economic growth and are a sign
of good things to come. BR

Business Review Q1 2007 9

REFERENCES

Backus, David, and Mario Crucini.
“Oil Prices and the Terms of Trade,”
Journal of International Economics 50
(2000), pp. 185-213.
Backus, David, and Patrick Kehoe.
“International Evidence on the
Historical Properties of Business
Cycles,” American Economic Review,
82, 4 (1992), pp. 864-88.
Backus, David, Patrick Kehoe, and
Finn Kydland. “International Business
Cycles: Theory and Evidence,” in
T. Cooley (ed.), Frontiers of Business
Cycle Research. Princeton: Princeton
University Press (1995).
Boileau, Martin. “Trade in Capital
Goods and the Volatility of Net
Exports and the Terms of Trade,”
Journal of International Economics
(1999), pp. 347-65.
Cavallo, Michele. “Understanding the
Twin Deficits: New Approaches, New
Results,” Federal Reserve Bank of San
Francisco Economic Letter, Number
2005-16 (July 22, 2005).

10 Q1 2007 Business Review
2007 Business Review

Chatterjee, Satyajit. “Real Business
Cycles: A Legacy of Countercyclical
Policies?” Federal Reserve Bank of
Philadelphia Business Review (January/
February 1999).
Gourinchas, Pierre-Olivier, and
Helene Rey. “International Financial
Adjustment,” National Bureau of
Economic Research Working Paper
11155 (2005).
Hodrick, Robert J., and Edward C.
Prescott. “Postwar U.S. Business
Cycles: An Empirical Investigation,”
Journal of Money, Credit, and Banking
29:1 (1997), pp. 1-16.
Leduc, Sylvain. “Globalization Is
Weaker Than You Think,” Federal
Reserve Bank of Philadelphia Business
Review (Second Quarter 2005).

Obstfeld, Maurice, and Kenneth S.
Rogoff. “Global Current Account
Imbalances and Exchange Rate
Adjustments,” Brookings Papers on
Economic Activity, 1 (2005), pp. 67146.
O’Rourke, Kevin H., and Jeffrey G.
Williamson. Globalization and History:
The Evolution of a Nineteenth-Century
Atlantic Economy. Cambridge, MA:
MIT Press (1999).
Roubini, Nouriel, and Brad Setser.
“The U.S. as a Net Debtor: The
Sustainability of the U.S. External
Balance,” mimeo, Stern School of
Business, NYU (September 2004).
Sill, Keith. “The Gains from
International Risk-Sharing,” Federal
Reserve Bank of Philadelphia Business
Review (Third Quarter 2001).

Obstfeld, Maurice, and Matthew
T. Jones. “Saving, Investment, and
Gold: A Reassessment of Historical
Current Account Data” in G. Calvo,
R. Dornbusch, and M. Obstfeld (eds.),
Money, Capital Mobility, and Trade:
Essays in Honor of Robert Mundell,
Cambridge, MA: MIT Press (2001).

www.philadelphiafed.org

The Great Moderation in Economic Volatility:
A View from the States
BY GERALD A. CARLINO

S

ince the middle of the 1980s, economic
growth in the U.S. has become much more
stable than it was in the preceding three
decades. And the magnitude of the decline
is substantial. What accounts for the decline in volatility,
and why is the decline important for policymakers? In
this article, Jerry Carlino discusses these questions and
makes the case that using state-level data, rather than
just national data, offers a much larger testing ground for
analyzing the decline in economic volatility.

Since the middle of the 1980s,
growth of the U.S. economy appears
to have become much more stable
than it was in the preceding three
decades. The magnitude of the decline in volatility is substantial: For
the nation, growth of output has been
one-half and growth of employment
two-thirds less volatile than they were
in the 1960s and 1970s. An aspect of
the change in volatility that has been
largely unexplored is its manifestation
at the sub-national level. Recently,
economists have started to look at the
Jerry Carlino is a
senior economic
advisor and
economist in
the Research
Department of
the Philadelphia
Fed. This article
is available free
of charge at www.
philadelphiafed.org/econ/br/index.html.
www.philadelphiafed.org

volatility of employment growth at the
state level. Studies have found that
while all states shared in the decline,
declines were more dramatic in some
states than in others.
What accounts for the decline in
volatility for the nation and its states?
The most common explanations for
the increased stability and lower volatility of the national economy include
structural change in the form of better
inventory control practices, improved
monetary policy since the late 1970s
and early 1980s, and good luck in the
form of smaller shocks hitting the
economy.1 But when accounting for
the various sources of the increased

1
Economists use the term shocks to refer to
unanticipated changes in economic variables.
Examples include unanticipated changes in
monetary and fiscal policy, extreme environmental conditions, and events that alter the
world price of energy.

economic stability, the national studies pay only modest attention to other
types of structural changes that may
have helped to lower volatility in
general, such as deregulation of the
banking industry, increased globalization, fewer unionized workers, and a
variety of demographic changes not
considered in the national studies. For
example, banking deregulation in the
1970s and 1980s may have contributed
to lower volatility by allowing consumers and firms to smooth spending over
time. Importantly, financial deregulation occurred at about the same time
that monetary policy is believed to
have improved. The national studies’
failure to take deregulation into account may have led to an overstatement of monetary policy’s role in the
great moderation.
Why is the decline in volatility
important to policymakers? Reduced
volatility of employment leads to less
economic uncertainty confronting
firms and households. Understanding
the forces that govern the volatility
of employment growth at the subnational level is important to both
national and local policymakers, since
volatility at the state and national levels are closely related. At the national
level, researchers have one observation
(the nation) to gain insight into these
forces. The advantage of using state
data is that such data offer a much
larger testing ground for conducting
the analysis.
TAKING STOCK OF THE
GREAT MODERATION
Growth of the U.S. economy
appears to have become much more
stable since the middle of the 1980s
Business Review Q1 2007 11

relative to the preceding three decades. A graph of the growth rate of
employment in the U.S. depicts this
increased stability. From the mid-1950s
to the early 1980s, quarterly employment growth largely fluctuated in a
range of around 2.0 percent to -1.5
percent. Since the mid-1980s, however,
employment growth has hovered in a
much narrower range: from less than 1
percent to about -0.5 percent (Figure
1).
The volatility of employment
growth can also be measured using the
standard deviation, which shows how
much employment growth moves up
and down around its average value.2
By this measure, average volatility of
U.S. employment growth fell from a
bit under 1.0 percent during the early
1960s to about 0.3 percent in 2005
(Figure 2). More specifically, volatility fell precipitously during the 1960s:
from a high of 0.96 during the second
quarter of 1962 to 0.31 during the
fourth quarter of 1969. Beginning in
the 1970s, employment growth volatility reversed its previously declining
trend and nearly tripled. This rise in
volatility coincides with the generally poor economic conditions of the
1970s, during which time the economy
experienced rising inflation and slow
growth. From the early 1980s on,
however, volatility generally declined
as economic performance improved
relative to the 1970s. This is an important period in that most studies have
tried to account for increased economic stability since the early 1980s.
Despite the general decline since the
mid-1980s, volatility temporarily increased during the 1990-91 recession
and the 2001 recession. Volatility fell

FIGURE 1
Quarterly Employment Growth
Percent
2.5
2
1.5
1
0.5
0
-0.5
-1
-1.5
-2

1952

1957

1963

1969

1975

1980

1986

1992

1998

2003

FIGURE 2
Standard Deviation of Total
Employment Growth Volatility
Percentage Points
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2

2

The data used in this article are quarterly from
1961:1-2005:2. The data were seasonally adjusted before computing our volatility measure.
Volatility is measured as the standard deviation
of employment growth over the previous 20
quarters.

12 Q1 2007 Business Review

0.1
0

1961

1966

1972

1978

1984

1989

1995

2001

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dramatically during the expansion in
the 1990s, as it has during the current
expansion.
There is a debate among economists about whether the decline in
volatility is best represented as a sudden one-time “break” around 1984
as opposed to a more moderate longrun decline in volatility over several
decades. Casual inspection of Figure
2 suggests that employment growth
volatility fell sharply in the mid-1980s.
The figure shows that volatility of employment growth fell from an average

of around 0.7 percent in the mid-1980s
to an average of about 0.3 percent
in 2005. Using a variety of statistical
methods, economists find evidence
that a one-time drop, or break, in volatility seems to have occurred around
1984. Following this convention, we
will look at the change in employment
growth volatility at the state level between two periods: 1956 to 1983 and
1984 to 2002.3
Table 1 shows that while all states
shared in the decline, employment
growth volatility declined much more

dramatically in some states than in
others. The state with the largest post3

See the article by Keith Sill for a discussion of
the two views: a one-time break in volatility vs.
a long-run gradual decline. While the various
measures used to analyze volatility have differed from study to study, all studies find that
volatility has declined since the mid-1980s. In
this article we assume that 1984 represents
the break date for each state, too. Michael
Owyang, Jeremy Piger, and Howard Wall report
finding differences in both the break date and
the magnitude of the reduction in volatility
across individual states. However, they did not
examine whether the break date they found for
any given state is significantly different from the
break dates found for other states.

TABLE 1
Change in Employment Growth Volatility by State*

State
West Virginia
Michigan
Ohio
Indiana
Pennsylvania
Alabama
Kentucky
Wisconsin
Arkansas
North Dakota
Washington
Minnesota
Oregon
Kansas
Idaho
Iowa
Tennessee
United States
Montana
Florida
Illinois
Nevada
Utah
Mississippi
Arizona

Percent Decrease in
Employment Growth Volatility:
1956-1983 to 1984-2002
75.9
63.6
57.8
57.1
56.9
53.8
53.7
52.5
52.1
51.9
50.2
47.4
47.3
46.0
46.0
45.3
44.6
43.9
43.2
42.9
42.7
42.2
41.3
40.7
39.3

State
New Mexico
Delaware
Maryland
Missouri
South Dakota
North Carolina
South Carolina
Louisiana
California
Wyoming
Colorado
Nebraska
Massachusetts
Rhode Island
Vermont
Connecticut
Georgia
Oklahoma
Texas
Virginia
Maine
New Jersey
New Hampshire
New York

Percent Decrease in
Employment Growth Volatility:
1956-1983 to 1984-2002
37.9
37.6
37.1
36.6
35.9
33.4
29.6
29.5
28.5
27.7
25.7
25.5
25.0
24.6
24.5
24.4
23.3
23.2
20.7
16.9
16.3
15.3
10.2
8.8

* Excluding Alaska and Hawaii

www.philadelphiafed.org

Business Review Q1 2007 13

war decline in employment growth
volatility is West Virginia, which saw
a drop of almost 76 percent. The state
with the smallest decline is New York,
at about 9 percent, compared with a
decline of about 44 percent nationally. Looking at the three states in the
Third Federal Reserve District, we find
that Pennsylvania was among the top
five states in terms of the decline in
the state’s employment growth volatility, falling almost 60 percent. The
decline in employment growth volatility in New Jersey (about 15.3 percent)
was well below the national average;
in Delaware (about 38 percent), it was
somewhat below the national average.
In general, similar declines in the
volatility of total employment growth
occurred at about the same time in
most major sectors. Figure 3 shows employment growth volatility by sector for
the nation for our two periods: 1956 to
1983 and 1984 to 2002.4 With the exception of the finance, insurance, and
real estate (FIRE) sector, the figure
shows more stable employment growth
by sector in the later period than in
the earlier one.
Table 2 shows the decline in volatility by state for two important sectors: manufacturing and services.5 The

4
Because of recent changes in the way industries are assigned to broad sectors, we do not
have a consistent series by sector that extends
back sufficiently through time. Thus, our analysis at the sectoral level ends in 2002. Since
industrial reclassification did not affect aggregate employment, the analysis using aggregate
data extends through 2005.
5
Services include personal services, business
services, educational services, and social and
other services. Services provided by finance,
insurance, and real estate industries are included in the FIRE sector. While manufacturing’s
share of national total employment has gone
down over time, services’ share has increased.
Taken together, manufacturing and services
have accounted for roughly 40 percent of total
national nonfarm employment since the 1950s.
The remaining 60 percent of national nonfarm
employment is accounted for by trade; government; transportation, communication, and
public utilities; mining; and construction.

14 Q1 2007 Business Review

FIGURE 3
Standard Deviation of
Employment Growth Volatility by Industry
Percent
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0

Mining

Construction

Manufacturing Transportation
& Utilities

1956-1983

state with the largest postwar decline
in manufacturing employment growth
volatility is Michigan, which experienced a 66 percent drop, while South
Dakota saw a 17 percent decline, the
smallest among all states. Manufacturing employment growth volatility fell
56 percent in the nation.
The change in employment
growth volatility for services is not
given for some states because of insufficient data in the earlier period. Since
the table shows the decline in volatility between the earlier and the later
period, a negative number for a state
indicates that employment growth
volatility increased in that state. While
employment growth volatility in the
services sector decreased a modest
2.5 percent for the nation between
the earlier and later period, there was
substantial variation across states. The
state with the largest decline in employment growth volatility in services

Trade

FIRE

Services

Government

1984-2002

was Kentucky, which experienced a
drop of 64 percent. On the other hand,
in Mississippi, employment growth
volatility in services increased almost
29 percent. Still, the vast majority
of states for which data are available
experienced declining volatility in
their service sectors, as well as in other
broad sectors.
SEEKING SOURCES OF THE
GREAT MODERATION
Economists have offered a number
of possible explanations for the decline
in the U.S. economy’s volatility. These
can be grouped under three broad
headings: better policy, good luck, and
structural change.
Better Policy. Economists have
noted that improved monetary policy
— the greater emphasis the Fed placed
on controlling inflation in the VolckerGreenspan years — might have dampened the effects of economic fluctua-

www.philadelphiafed.org

TABLE 2
Percent Decrease in Volatility:
1956-1983 to 1984-2002*
State
United States
Alabama
Arizona
Arkansas
California
Colorado
Connecticut
Delaware
Florida
Georgia
Idaho
Illinois
Indiana
Iowa
Kansas
Kentucky
Louisiana
Maine
Maryland
Massachusetts
Michigan
Minnesota
Mississippi
Missouri
Montana
Nebraska
Nevada
New Hampshire
New Jersey
New Mexico
New York
North Carolina
North Dakota
Ohio
Oklahoma
Oregon
Pennsylvania
Rhode Island
South Carolina
South Dakota
Tennessee
Texas
Utah
Vermont
Virginia
Washington
Wisconsin
West Virginia
Wyoming

Manufacturing Employment
55.7
56.5
45.0
56.6
44.3
46.3
50.9
23.2
48.4
46.2
56.8
55.7
63.1
48.8
63.0
56.9
36.5
37.8
55.6
36.0
66.3
45.5
42.7
45.5
54.5
36.7
52.7
32.8
45.9
35.1
50.2
43.0
53.8
64.3
33.0
46.9
63.1
48.9
43.4
17.4
50.9
39.1
45.4
54.1
43.5
32.7
56.9
56.0
39.1

Services Employment
2.5
5.4
10.3
24.6
20.1
14.8
1.3
N/A
36.6
24.2
39.5
-3.0
40.6
31.1
24.2
63.8
25.2
N/A
N/A
N/A
N/A
18.6
-28.5
-5.8
25.5
25.0
47.4
32.6
-5.0
39.6
-2.7
18.7
6.2
17.6
18.5
22.2
20.5
N/A
18.9
30.1
11.8
4.3
N/A
31.8
-12.9
26.3
41.2
39.2
62.3

tions, leading to a more stable economy. According to Olivier Blanchard
and John Simon, the volatility of
output and the volatility of inflation
have tended to display a strong positive
correlation. Low and stable inflation
makes economic planning easier and
improves the functioning of markets.
Stable inflation may contribute to
more stability in the growth of output
and employment.
In the pre-Volcker era, monetary
policy was characterized as “accommodative” in that policymakers did not
respond strongly enough to keep inflationary pressures under control. The
conduct of monetary policy appears to
have changed significantly beginning
in the Volcker era in an effort to bring
high and rising inflation pressures under control.6 A recent study by James
Stock and Mark Watson shows that
the increased stability of output and
employment since the mid-1980s is
partly due to monetary policymakers’
greater emphasis on inflation and their
success at controlling it. In studying
the various sources of the moderation
in output volatility since the mid1980s, Stock and Watson find that
better monetary policy since the early
1980s accounts for about 20 percent
of the decline in volatility.7 Still, Stock
and Watson find that half the decline
in volatility is unaccounted for and
they attributed it to sheer luck.
Good Luck. The word “shock”
represents economists’ shorthand for
a factor or force that causes an unex-

6

Paul Volcker served as Chairman of the Federal Reserve from 1979 to 1987. Alan Greenspan,
who succeeded Volcker, served as Chairman
from 1987 to 2006.

7

Sylvain Leduc and Keith Sill also assessed the
importance of monetary policy for the decline
in U.S. output volatility that has occurred since
the mid-1980s. They find that improved monetary policy accounted for about 10 percent of
the decline in real output volatility, half the size
found by Stock and Watson.

* Excluding Alaska and Hawaii
www.philadelphiafed.org

Business Review Q1 2007 15

pected change in an economic variable, such as employment growth. Examples include weather-related events,
strikes, and domestic and foreign political crises. To the extent that volatility is the result of large adverse shocks,
it will decline if these unlucky events
are smaller in magnitude or happen
less frequently. Hurricanes and other
weather-related events represent a type
of shock that affects states differently.
The damage done to Louisiana, Mississippi, and Alabama by Hurricane
Katrina is an obvious case. As we have
indicated, a substantial part of the
decline in national volatility cannot be
accounted for and may be due merely
to good luck. Unfortunately, the good
luck the economy has experienced
since the mid-1980s may be temporary.
If the bad luck the economy experienced prior to the mid-1980s returns,
economic volatility may increase.
Structural Changes. Many types
of structural changes may have helped
to lower the volatility of employment,
such as the shift of jobs from manufacturing to services, better inventory
management methods, fewer unionized
workers, and banking deregulation.
Redistribution of jobs. Perhaps the
most intuitive explanation for the decline in employment growth volatility
in the mid-1980s involves the shift of
employment from the relatively more
volatile goods-producing sector to the
relatively less volatile services sector.
According to this view, manufacturing contributed more to the decline
in volatility than other sectors, both
because manufacturing is a relatively
high-volatility sector and because
manufacturing’s share of employment
has declined.8
Manufacturing’s share of total
U.S. employment fell from an average
of 27 percent between 1956 and 1983
to an average of just over 16 percent
between 1984 and 2002. At the same
time, services’ share increased from

16 Q1 2007 Business Review

FIGURE 4
Ratio of Manufacturing to Services
Employment Volatility
Ratio
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0

1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000

an average of about 17 percent in the
earlier period to an average of 27 percent in the later period. In the earlier
period, manufacturing employment
growth was, on average, almost twice
as volatile as employment growth in
services. While manufacturing continues to be more volatile than services,
the gap has narrowed substantially. In
the later period, manufacturing employment growth was, on average, only
about 50 percent more volatile than
was employment growth in services.
Figure 4 shows the volatility of manufacturing employment growth relative

8

Although volatility in the mining and construction sectors fell more than volatility in the
manufacturing sector, the share of employment
in both the mining and the construction sectors
accounts for at most about 6 percent of total
U.S. employment. Given their relatively small
share of total employment, these two sectors
contribute very little to the decline in total
employment volatility, despite the relatively
large declines in volatility recorded by industries
in these sectors.

to the volatility of services employment
growth. After declining for the better
part of the 1960s, relative volatility
increased somewhat between the late
1960s and early 1970s, before increasing dramatically in the period 1973 to
1979. The jump in relative volatility
is largely due to a jump in volatility in
manufacturing. The disruption in oil
supplies in the 1970s may have led to
much greater volatility in manufacturing than in services. Of importance for
this article is the sharp drop in relative
volatility since the mid-1980s, which
is consistent with the observed sharp
drop in the volatility of total employment growth.9
How much does the shift of jobs
from the relatively high-volatility sec9

A couple of studies have found that energy
price shocks since the mid-1980s have played
virtually no role in accounting for the increased
stability of the national economy. See the article by Stock and Watson and the one by Leduc
and Sill.

www.philadelphiafed.org

tors to the relatively low-volatility sectors matter in explaining the overall
decline in employment growth volatility? To address this issue, we conducted an experiment in which we constructed a hypothetical series for total
employment growth, holding each
industry’s share of total employment
fixed at its 1961 level. Since industry
shares are held constant at their 1961
levels over the period 1961 to 2002, all
of the variability in the hypothetical
series will be due to changing volatility
in the various sectors.10 Figure 5 shows
hypothetical volatility juxtaposed with
actual volatility. The volatility of the
hypothetical series is generally above
that of the actual series. Still, the
largest difference between the hypothetical series and the actual series is
in the 1970s and early 1980s. The difference between these two series was
much narrower after 1984, suggesting
that the shift of jobs away from manufacturing is not an important cause
of the decline in volatility since the
mid-1980s. In fact, two recent studies
using state-level data on volatility and
a statistical technique called regression
analysis find that the redistribution of
jobs toward the less volatile sectors has
played only a minor role in accounting
for the decline in employment volatility observed since the mid-1980s.11
Better inventory management.
Some studies point to innovation in
inventory management techniques
(such as the explosion in information

10
To construct the hypothetical series, employment growth rates for each major industry for
each year were weighted by each industry’s 1961
share of total employment. The hypothetical
employment growth series was used to compute
the hypothetical volatility (defined as the standard deviation of employment growth over the
previous 20 quarters) shown in Figure 5.
11

See my study with Robert DeFina and Keith
Sill and the study by Owyang, Piger, and Wall
for evidence on the role of the shift of jobs from
manufacturing to services in explaining changing employment growth volatility.

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FIGURE 5
Hypothetical and Actual Volatility
in Total Employment Growth
Standard Deviation
1.2

1
Hypothetical
0.8

0.6

0.4
Actual Employment Shares
0.2

0
1961

1964

1968

1972

1976

1979

technology and just-in-time production
techniques) that have allowed firms to
better use inventories to smooth production and employment. For example,
just-in-time inventory techniques allow producers to maintain lower stock
levels and to better match production
with sales. Changes in demand result
in smaller swings (that is, less volatility) in production now than in past
decades. Despite this theory’s appeal,
the extent to which improved inventory management methods have contributed to increased stability is subject
to some debate by economists and the
question of its role is far from settled.12
Fewer unionized workers. Other

12

See the article by James Kahn, Margaret
McConnell, and Gabriel Perez-Quiros for a
discussion of the role of improved inventory
management in the decline in economic volatility. The bulk of the research suggests little role
for inventories in reducing volatility. See the
article by Keith Sill for a good review of the
relevant studies.

1983

1987

1991

1994

1998

2002

types of structural changes, such as
fewer unionized workers and increased
globalization, may also have been at
work, and these changes may have
helped to lower volatility. For example,
an important structural change is the
sharp drop in the number of union
members over the past 40 years. In
1964, almost 30 percent of workers
were union members. By 1994, the
share had fallen to less than 13 percent. In fact, the decline in the share
of unionized workers accelerated after
1980. Between 1964 and 1980, the
share of workers covered by unions
fell about 1.3 percent per year, but the
share fell about 1.8 percent per year
between 1980 and 2004. The acceleration in the decline of unionized workers after 1980 may have contributed to
the economy’s increased stability.
Why might employment volatility
decrease as the number of unionized
workers decreases? Since unions are
generally unwilling to accept decreases

Business Review Q1 2007 17

in work hours and wages, when demand falls, unionized firms can adjust
only by changing employment. When
demand improves, unionized firms
rehire many of the same workers they
laid off during bad times. These layoffs
and subsequent rehires may induce
greater volatility in employment
growth than would have occurred if
wages had borne more of the adjustment to changing demand. But the
decline in the share of unionized workers occurred gradually, making it an
unlikely explanation for the sharp drop
in volatility we observe.
Banking deregulation. An important type of structural change
that began in the early 1980s was the
deregulation of the banking industry.
Until the 1980s, commercial banks
in the U.S. faced restrictions on the
interest rates they could pay depositors
and charge borrowers. When market
interest rates rose above the legal ceilings that banks were allowed to pay
for deposits, many depositors withdrew
their funds from the banking system.
This led to a drop in the amount of
credit that banks could extend to firms
and households, thereby hurting bankdependent borrowers.
Housing in the 1960s and 1970s
was particularly hard hit when market
interest rates rose above these interest
rate ceilings. But once the ceilings
were removed in the 1980s, banks
and savings and loans were able to
offer competitive interest rates to
their depositors, thus preventing a
wholesale withdrawal of deposits and
allowing banks to continue to make
construction and mortgage loans.
In fact, economists Karen Dynan,
Douglas Elmendorf, and Daniel Sichel
show that there has been a substantial
decline in the volatility of residential
investment since the mid-1980s.
Until the 1980s, banks also faced
geographic limitations in that bank
holding companies were not permitted

18 Q1 2007 Business Review

to cross state borders. The geographic
restrictions also made banks’ ability
to lend more vulnerable to economic
shocks that affected their own states.
In the absence of a national banking
system integrated across states, the allocation of funds and the resulting distribution of money and credit can be
uneven. That is, it can get "stuck" in a
state, depending on where and how the
deposit and withdrawal activity takes
place. In this case, money and credit
would flow less easily from one state to
another in the face of a state shock.
Although banking markets tended

Strahan finds that state employment
volatility fell substantially after interstate banking was permitted.13 States
deregulated their banking sectors at
different times. In 1978, Maine was the
first state to pass a law that allowed
entry by bank holding companies from
any state that reciprocated by allowing Maine banks to enter their banking markets. Following Maine’s lead,
states deregulated in waves, with the
bulk of states approving legislation to
allow deregulation between 1985 and
1988. With the exception of Hawaii,
all states allowed interstate banking

Until the 1980s, banks also faced geographic
limitations in that bank holding companies
were not permitted to cross state borders.
to be local in nature prior to deregulation, a bank in one state that needs
money could borrow in national credit
markets, such as the fed funds market
(borrowing of funds overnight from
other banks), through bank holding
companies that issue commercial paper to raise funds, and the Eurodollar
market (deposits from banks outside
the U.S.). However, raising funds in
these national and international markets imposed some additional costs on
banks, and these costs may have limited banks’ willingness to raise funds
from these sources.
Today, most of these restrictions on commercial banks have been
phased out. Shocks to a state can be
met with inflows or outflows of funds,
and thus, the adjustment to the shock
is likely to be smoother. In essence,
deregulation made the banking system
more efficient and, in the process, allowed the financial sector to act more
as a stabilizer for the real sector.
A recent study by Donald Morgan, Bertrand Rime, and Philip

by 1993. In their study, Morgan, Rime,
and Strahan use the staggered timing
in state-level action to relax interstate
banking restrictions to explain some of
the cross-state differences in employment growth volatility as well as the
increased stability of state economies.
They conclude that the increased
stability following regulatory change
made state economies much less sensitive to the fortunes of their own banks.
The finding that interstate banking appears to have contributed to
increased economic stability raises an

13
According to the theory developed in Morgan, Rime, and Strahan’s study, it’s possible
for volatility to rise, fall, or remain mostly
unchanged following legislation that allowed
interstate banking. Deregulation’s net effect
on employment growth volatility is, therefore,
an empirical issue. As indicated in the study
by Morgan and co-authors, the net effect is, on
balance, negative, suggesting that employment
volatility became more stable after interstate
banking was allowed than before such deregulation. For a discussion of why deregulation’s net
effect on employment growth volatility might be
positive, see the article by Philip Strahan.

www.philadelphiafed.org

important concern with Stock and
Watson’s study, which attributed 20
percent of reduced volatility since
the mid-1980s to improved monetary
policy. Since financial deregulation
occurred at roughly the same time that
monetary policy is supposed to have
improved, it’s possible that the Fed did
not make as substantial a contribution
to increased stability as some believe;
rather, banks were better able to implement monetary policy decisions following deregulation. By not controlling
for financial deregulation, Stock and
Watson may have overstated monetary
policy’s role in lowering volatility.
Similarly, while Morgan and
co-authors considered banking
deregulation’s contribution to volatility, they did not adequately control
for the role that improved monetary
policy may have played. In their study,
Morgan and co-authors account for
the common or average effect of monetary policy on state volatility. In an
earlier Business Review article, Robert
DeFina and I found that monetary
policy affects economic activity in the
states quite differently. It’s conceivable that changes in the conduct of

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monetary policy may have contributed
to substantial state-level deviations in
the growth of employment volatility
from the average effect measured by
Morgan and co-authors. If the unaccounted-for differences in the impact
of monetary policy are correlated with
the date at which states deregulated,
Morgan and co-authors’ estimates of
deregulation’s effect on the volatility of
employment growth may be overstated.
We believe there is evidence of such
bias.14 To date, no study has accounted
adequately for both forces — improved
monetary policy and deregulation
— simultaneously.

14
States that tend to be more sensitive to monetary policy actions might have deregulated earlier than states that are less sensitive to policy
actions in an attempt to smooth employment
volatility in the more responsive states. This
would impart a negative correlation between
the differential state responses to monetary
policy action and the timing of banking deregulation. Using estimates of the differential state
responses to monetary policy action reported in
my paper with Robert DeFina, I found a negative (-0.278) and significant correlation between
differential state responses to monetary policy
action and the timing of banking deregulation.

CONCLUSION
The question of what generates
volatility in employment growth at the
state level is closely related to what
generates volatility at the national level. Understanding the forces that govern employment growth volatility at
the sub-national level is important to
both national and local policymakers.
While progress has been made in identifying some of the sources of the great
moderation, there appear to be other
forces at work that could improve our
understanding of the increased stability of local and national economies.
While some studies have looked at the
relative roles that the shift of jobs to
services, better inventory management,
better monetary policy, and financial
deregulation have played in producing a more stable economy, no study
has satisfactorily controlled for all of
these forces simultaneously. Accounting for all of these forces together is an
important next step to understanding
the relative contributions these various
forces may have individually played in
explaining the great moderation. BR

Business Review Q1 2007 19

REFERENCES

Bernanke, Ben S. “The Great
Moderation,” speech at the
Eastern Economic Association,
Washington (February 20, 2004).
www.federalreserve.gov/boarddocs/
speeches/2004/20040220/default.
htm#f1

Dynan, Karen, Douglas Elmendorf,
and Daniel Sichel. “Can Financial
Innovation Help to Explain the
Reduced Volatility of Economic
Activity?,” Journal of Monetary
Economics, 53, 1 (January 2006), pp.
123-50.

Blanchard, Olivier, and John Simon.
“The Long and Large Decline in U.S.
Output Volatility,” Brookings Papers
on Economic Activity 1:2001 (2001),
pp. 135-64.

Kahn, James, Margaret McConnell,
and Gabriel Perez-Quiros. “On the
Causes of the Increased Stability of the
U.S. Economy,” Federal Reserve Bank
of New York Economic Policy Review
(May 2002), pp. 183-202.

Carlino, Gerald, and Robert DeFina.
“Do States Respond Differently to
Changes in Monetary Policy?” Federal
Reserve Bank of Philadelphia Business
Review (March/April 1999).
Carlino, Gerald, Robert DeFina, and
Keith Sill. “Postwar Period Changes in
Employment Volatility: New Evidence
from State/Industry Panel Data,”
Working Paper 03-18, Federal Reserve
Bank of Philadelphia (2003).

20 Q1 2007 Business Review

Leduc, Sylvain, and Keith Sill.
“Monetary Policy, Oil Shocks, and
TFP: Accounting for the Decline in
U.S. Volatility,” Working Paper 03-22/
R, Federal Reserve Bank of Philadelphia (2003).
Morgan, Donald, Bertrand Rime, and
Philip Strahan. “Bank Integration
and State Business Cycles,” Quarterly
Journal of Economics (November 2004),
pp. 1555-84.

Owyang, Michael, Jeremy Piger, and
Howard Wall. “A State-Level Analysis
of the Great Moderation,” unpublished
manuscript, Federal Reserve Bank of
St. Louis (September 14, 2005).
Sill, Keith. “What Accounts for
the Postwar Decline in Economic
Volatility?” Federal Reserve Bank of
Philadelphia Business Review (First
Quarter 2004).
Stock, James, and Mark Watson.
“Has the Business Cycle Changed and
Why?” NBER Working Paper 9127
(August 2002).
Strahan, Philip E. “The Real Effects of
U.S. Banking Deregulation,” Federal
Reserve Bank of St Louis Review (July/
August 2003).
“The Unfinished Recession: A Survey
of the Word Economy,” The Economist,
September 28, 2002.

www.philadelphiafed.org

The Macroeconomics of Oil Shocks
BY KEITH SILL

F

or various reasons, oil-price increases may
lead to significant slowdowns in economic
growth. Five of the last seven U.S. recessions
were preceded by significant increases in
the price of oil. In this article, Keith Sill examines the
effect of changes in oil prices on U.S. economic activity,
focusing on how runups in the price of oil can affect
output growth and inflation. He also discusses the
channels by which oil-price increases might affect the
economy and the historical evidence on the relationship
between oil prices, economic growth, and inflation.

During the first quarter of 2002,
the price of crude oil averaged $19.67
per barrel. Four years later, in the first
quarter of 2006, the average price of
oil had risen to $63 per barrel. Indeed, the high price of oil may not be a
short-lived phenomenon: Futures markets indicate that investors expect the
price of oil to remain above $70 per
barrel through 2008. For the postwar
U.S. economy, the data show a clear
tendency for oil-price spikes to precede

Keith Sill is a
senior economist
in the Research
Department of
the Philadelphia
Fed. This article
is available free of
charge at: www.
philadelphiafed.org/
econ/br/index.html.

www.philadelphiafed.org

economic downturns. Though most
of these episodes occurred at a time
when oil’s share as an input into U.S.
production was larger than it is today,
there is still much debate about how
oil prices affect the economy. How
concerned should we be about the
economic consequences of persistently
high oil prices?
Oil prices matter for the economy
in several ways. Changes in oil prices
directly affect transportation costs,
heating bills, and the prices of goods
made with petroleum products. Oilprice spikes induce greater uncertainty
about the future, which may lead to
firms’ and households’ delaying purchases and investments. Changes in
oil prices also lead to reallocations
of labor and capital between energyintensive sectors of the economy and
those that are not energy-intensive.
For these reasons and others, oil-

price increases may lead to significant
slowdowns in economic growth. In
the postwar U.S. data, the correlation
between oil-price spikes and economic
downturns is not perfect — some
oil-price increases are not followed
by recessions. But five of the last
seven U.S. recessions were preceded
by significant increases in the price of
oil. The most recent rise in the price
of oil has not led (at least not yet) to
an economic recession, but history
nonetheless suggests that oil prices are
an important element in assessing the
economy’s near-term prospects.
OIL PRICES
From the late 1940s to the early
1970s, the price of oil was very stable,
moving up only slightly.1 From the early 1970s to the early 1980s, the price
of oil rose dramatically in a sequence
of steps associated with the rise of
OPEC and disruptions in the supply of
oil from the Middle East oil-producing
countries (Figure 1).2

1
From 1948 to 1972, the price of oil produced
in the U.S. was influenced by the production
quotas set by the Texas Railroad Commission
(TRC). Each month, the TRC (and other state
regulatory agencies like it) made forecasts of
petroleum demand for the upcoming month and
set production quotas to meet the forecasted
demand. Since the quantity of oil produced was
adjusted to meet forecasted demand, the price
of oil remained fairly stable. However, in the
face of growing world demand for oil relative
to supply, and the peaking of U.S. domestic oil
production in 1970, the TRC set the production
quotas at 100 percent in March 1971.
2
The Organization of Petroleum Exporting
Countries (OPEC) was formed in 1960 with
five founding members: Iran, Iraq, Kuwait,
Saudi Arabia, and Venezuela. By the end of
1971, Qatar, Indonesia, Libya, the United Arab
Emirates, Algeria, and Nigeria had joined.

Business Review Q1 2007 21

FIGURE 1
Nominal Price of Crude Oil
Dollars / Barrel
70

60

50

40

30

20

10

Source:

Jan-04

Jan-02

Jan-98
Jan-00

Jan-96

Jan-94

Jan-90
Jan-92

Jan-88

Jan-84
Jan-86

Jan-76
Jan-78
Jan-80
Jan-82

Jan-74

Jan-70
Jan-72

Jan-68

Jan-62
Jan-64
Jan-66

Jan-58
Jan-60

Jan-54
Jan-56

Jan-52

Jan-50

0

Haver Analytics. Price of West Texas Intermediate.

OPEC first experienced the power
it had over the price of oil during the
Yom Kippur War, which started in
October 1973. As a result of U.S. and
European support of Israel, OPEC
imposed an oil embargo on western
countries. Oil production was cut by 5
million barrels a day (though about 1
million barrels a day in production was
made up by other countries). The cutback amounted to about 7 percent of
world production, and the price of oil
increased 400 percent in six months.
From 1974 to 1978 crude-oil prices
were relatively stable, ranging from $12
to $14 per barrel. The next big round
of oil-price increases came with the
Iranian revolution and Iran-Iraq war
in 1979 and 1980. World production
fell 10 percent, and this resulted in the
price of oil rising from $14 to $35 per
barrel. However, the high price of oil
was leading consumers and firms to
conserve energy. Homeowners insu-

22 Q1 2007 Business Review

lated their houses. Commuters bought
more fuel-efficient cars. Firms bought
equipment that was more energy efficient. High oil prices also led to
increased exploration and production
of oil from countries outside of OPEC.
From 1982 to 1985 OPEC sought
to stabilize the price of oil through
production quotas, but conservation
efforts, a global recession, and cheating on production quotas by OPEC
members eventually led to a plummeting of oil prices to below $10 per barrel
by 1986.3
Since the mid-1980s the frequency
of oil-price changes has been much
greater than in the past. OPEC continued to influence the price using pro3

Over the period 1982-86, Saudi Arabia
acted as the marginal oil producer, cutting its
production in an effort to keep oil prices from
falling. In August 1982, the Saudis abandoned
that strategy and linked their oil price to the
spot market for crude.

duction quotas, but it has been unable
to stabilize it. In fact, OPEC’s share of
world oil production has fallen from a
peak of 55 percent in 1973 to about 42
percent today. U.S. imports of oil from
OPEC, as a share of total petroleum
imports, peaked at 70.3 percent in
1977 and have since fallen to about 43
percent.4 Today, the major suppliers of
imported oil for the U.S. are Canada
and Mexico, followed by Saudi Arabia
and Venezuela.
Oil Prices, Recessions, and
Inflation. We can plot the real price
of oil, that is, the price of oil adjusted
for inflation, the rate of inflation as
measured by the consumer price index
(CPI), and U.S. recessions as defined
by the National Bureau of Economic
Research (Figure 2). The figure indicates that even with the substantial
runup in the nominal price of oil
since 1999, oil remains cheaper, in
real terms, than it was during the late
1970s.
A striking aspect of the postwar
history of oil prices and the economy
is that oil prices spike upward right
around the time of recessions. A clear
relationship between oil prices and
inflation is harder to discern. During
some episodes, such as 1973-74 and
1980, it appears that inflation rises at
the same time that the price of oil
rises. At other times, such as 2002 to
the present, oil prices rise while inflation remains stable. The figure suggests
that the relationship between oil-price
increases and the real economy might
be stronger than the relationship between oil prices and inflation.
A characteristic of the oil-price
spikes that occur around recessions
is that they tend to be both large and

4

U.S. oil production peaked at 9.6 million
barrels a day in 1970 and has since fallen to
about 5.4 million barrels a day. Even at that
rate, the U.S. remains one of the world’s largest
oil producers. In fact, only Saudi Arabia and
Russia produce more oil in a year than the U.S.

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WHY MIGHT OIL-PRICE SPIKES
CAUSE RECESSIONS?
Is it plausible that an increase
in the price of oil leads to recession
when oil represents such a small (and
declining) share of U.S. output? Oil
consumption as a share of gross domestic output (GDP) was slightly below 4.5
percent in the early 1970s, but it has
since declined steadily to a little over 2
percent in 2004 (Figure 3).5 How could
a change in the price of an input that
represents such a small share of the
5

Oil consumption is measured using the Energy
Information Administration’s data on U.S. total
crude oil and petroleum products supplied to
U.S. households, firms, and government.

www.philadelphiafed.org

FIGURE 2
Real Oil Price & CPI Inflation
Dollars
60

50

40
Real Oil Price
30

20

10

0
CPI Inflation

Source:

Jan-04

Jan-02

Jan-98
Jan-00

Jan-96

Jan-94

Jan-90
Jan-92

Jan-88

Jan-84
Jan-86

Jan-76
Jan-78
Jan-80
Jan-82

Jan-74

Jan-70
Jan-72

Jan-68

Jan-62
Jan-64
Jan-66

Jan-58
Jan-60

Jan-54
Jan-56

Jan-52

-10
Jan-50

abrupt. By abrupt, we mean that the
price changes are sharp upward movements rather than slow and gradual
upward drifts. Historically, the prerecession spikes are associated with
disruptions in supply from the Middle
East. These supply disruptions tend
to be associated with wars that led to
significant reductions in the amount
of oil exports by the affected countries
(see the table). The table shows that
Middle East conflicts led to rather
large reductions in the world supply
of oil. Absent a large drop in demand,
such large supply disruptions could
lead to large increases in the world
price of oil. The table confirms that
U.S. business-cycle peaks also tended
to occur close in time to the dates of
the conflicts. Note, though, that the
length of time between the oil-supply
disruption and the business-cycle peak
varies, ranging from about contemporaneously to a little over one year.
What the table and Figure 2 by themselves cannot tell us is whether oilprice increases or Middle East conflicts
or some other factor, such as monetary
policy, led to recessions in 1957, 1973,
1980-81, and 1990. However, the data
suggest the possibility of a link between oil and the macroeconomy.

Haver Analytics. Real oil price is West Texas Intermediate price divided by CPI inflation.

economy have such a dramatic economic effect?
Oil prices affect the economy
through a multitude of channels.
When all of these effects are added up,
oil prices could have a larger impact
than what might be expected from oil’s
small share in the economy. The key
is that oil-price changes affect both
supply and demand. Changes in oil
prices affect supply because they make
it more costly for firms to produce
goods; they affect demand because
they influence wealth and can induce
uncertainty about the future.
First, let’s consider this: An oilprice increase acts like a tax on firms
and households. The United States
imports a large fraction of the oil it
uses from other countries, and the payments we make to foreign countries for
oil represent an outflow of funds from
the U.S. Higher payments to foreigners for oil reduce income available for

spending on other goods and services.
The lower demand for domestically
produced goods and services might
mean lower production of goods and
services. The demand effect is stronger
if the foreign countries to which we
make payments for oil do not trade
much with the U.S. That means that
the dollars spent on oil do not get recycled to the U.S. economy in the form
of foreign purchases of U.S. goods and
services.6
A second channel by which a
jump in the price of oil can reduce output growth comes from the manner in
which energy and capital, such as machines, are used in production. Energy
and capital are largely complements
in production, which means that to
6
However, dollars may get recycled back to
the U.S. economy if petroleum-producing
countries purchase U.S. assets. Such purchases
could drive down U.S. interest rates and boost
consumption and investment.

Business Review Q1 2007 23

TABLE
Middle East Conflicts and Effects on Oil Supply

Date

World Supply
Disruption

Recession Date

10.1%

Event

Months
from Disruption to
Cycle Peak

Aug. 1957

8

Nov. 1956

Suez Crisis

Nov. 1973

Yom Kippur War

7.8%

Nov. 1973

0

Nov. 1978

Iranian Revolution

8.9%

Jan. 1980

13

Oct. 1980

Iran-Iraq War

7.2%

July 1981

8

Aug. 1990

Persian Gulf War

8.8%

July 1990

-1

Source: Hamilton (2003). The table lists the major Middle East conflicts since 1950, the amount by which the conflict reduced the world supply of oil,
and the number of months to the onset of the nearest U.S. recession.

run machines you need energy, and to
run machines more intensively takes
more energy. If energy becomes more
expensive, firms may have to purchase
new energy-efficient machines if they
want to maintain profit margins. Firms
stuck with less fuel-efficient machines
see their profit margins suffer, and
so they may invest less in capital and
labor. Firms may also delay or change
their investment plans in response to
a rise in the price of oil. These various
investment factors slow both demand
in the economy as a whole and the
economy’s rate of output growth.
In addition, oil-price changes
might have reallocative effects on the
economy. Some sectors use energy
more intensively than others. For example, the transportation sector is a
heavy user of petroleum products compared with the trade sector. When the
price of oil rises, the transportation
sector is affected relatively more, leading to flows of capital and labor out of
transportation and into other sectors
of the economy. This labor and capital
reallocation has a short-term negative

24 Q1 2007 Business Review

effect on output as unemployed and
underemployed resources seek new
uses.
Empirical studies have attempted
to quantify the extent of reallocation
in response to changes in the price
of oil. Research by Steven Davis and
John Haltiwanger found that oil-price
increases account for about 20 to 25
percent of the variability of employment growth in the manufacturing
sector. Furthermore, firms that had
higher capital intensity and higher
energy intensity made greater adjustments to their workforces in response
to oil-price increases.
Oil-price increases may also lead
consumers and firms to delay their
purchases of certain types of goods.
For example, a household may decide
that it wants to purchase an SUV. If
oil prices jump up, the household
might decide to hold off on the purchase until it becomes clearer how
long-lasting the oil price increase is
likely to be. Similarly, firms may delay
investing in certain types of equipment
until uncertainty about the future

price of oil is somewhat resolved. Thus,
whether an oil-price hike is perceived
as temporary — lasting only a month
or two — or long-lasting can potentially have a significant impact on
spending decisions by consumers and
businesses.
The Asymmetric Effect of OilPrice Changes. How can we pin
down the link between oil prices and
the macroeconomy? As we saw in
Figure 2, some oil-price increases could
lead to recessions. What about oilprice decreases? Do they lead to faster
output growth? Interestingly enough,
the answer is no. A significant feature
of the empirical relationship between
oil prices and real output is that oil
prices have an asymmetric effect on
output: Oil-price increases slow output
growth, but oil-price decreases do not
boost output growth.
A possible reason behind this
asymmetric effect of oil prices on
growth is the interaction of the supply, demand, and reallocation effects.
Rising oil prices affect supply because
firms now find it more expensive to

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FIGURE 3
Share of Oil Consumption in GDP
Percent
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5

Source:

2004

1999

1994

1989

1984

1979

1974

1969

1964

1959

1954

1949

0

U.S. Energy Information Administration and Haver Analytics.

produce goods because of higher energy costs. Demand may be affected
as well, since consumers and firms are
likely to be uncertain about how long
oil prices will remain high and what
the implications are for investment
and purchases of durable goods. Both
of these factors decrease real output.
In addition, the reallocation of resources across sectors of the economy
in response to higher oil prices slows
economic growth.
Now consider what happens when
oil prices fall. Again, there is a supply effect: Firms now find it cheaper
to produce goods, which encourages
increased production. Lower oil prices
are likely to increase demand as well.
But the reallocation effect still slows
growth as resources move across sectors in response to lower oil prices. On
net, all of these factors may wash out,
so that the effect of a decrease in the
price of oil is just about nil. This might

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explain the asymmetric effect of oilprice changes on the economy.
The asymmetric effect of oil-price
shocks on output growth is key to
understanding a second prominent
feature of the link between oil and
the macroeconomy: The relationship
between oil-price changes and real
output growth is much stronger before
1985 compared with after 1985.7 Before
1985, there is strong statistical evidence that oil-price changes predicted
real output growth. After 1985, this
relationship breaks down. What has
happened?
Recall from Figure 2 that before
1980, large changes in the price of oil
were upward. If increases in oil prices
lead to slower economic growth (asym7
Economists use the term shock to refer to
unanticipated changes in economic variables.
Examples include unanticipated changes
in monetary and fiscal policy, extreme
environmental conditions, and events that alter
the world price of energy.

metry), the pre-1980 data contain
many instances of oil-price increases
to examine that hypothesis. Indeed,
before 1980, there is a strong prediction that oil-price increases lead to
slower growth. After 1980, oil-price
changes are both positive and negative.
If only positive oil-price changes affect
economic growth, all of the negative
price changes in the data make it
more difficult to uncover the effect of
oil-price changes on output, since the
negative price changes would attenuate the measured effect of the positive
price changes. The net result of the
asymmetric effect of oil-price increases
coupled with lots of oil-price decreases
in the data after 1985 would lead to
a much weaker measured relationship between oil prices and economic
growth.
Of course, just because oil-price
increases appear to predict slower real
output growth does not mean that oilprice increases cause slower real output growth. It could be the case that
when the economy is strong and real
output growth is high, resulting high
demand for oil pushes up the price of
oil. (When the economy weakens and
demand for oil slows, there is downward pressure on the price of oil.) This
type of feedback from the economy
to oil prices could end up looking a
lot like oil-price increases causing recessions, even though it is really the
economy that is driving up oil prices,
because oil prices would be high prior
to a slowdown in growth. If we want to
understand whether oil-price increases
actually cause recessions, we have to
control for the feedback effect of the
economy and demand on oil prices.
OIL-PRICE INCREASES CAUSED
BY EXTERNAL FACTORS
Research by James Hamilton
discusses the problem of feedback from
the economy to oil prices and poses a
solution. If we want to control for the

Business Review Q1 2007 25

feedback from real output growth to
oil prices, we should identify jumps in
the price of oil that are not caused by
U.S. economic conditions.8 That is, we
want to identify oil-price increases that
are external to U.S. economic conditions and then investigate whether
these oil-price increases caused by
external factors predict slower output
growth.9 We can then plausibly argue
that since those oil-price increases are
not a result of U.S. economic conditions, any relationship between these
price increases and slower real output
growth is in the direction from oilprice increases to real output growth.
This would be a key piece of evidence
in arguing that oil-price increases can
lead to economic downturns.
How can we find external oil-price
increases in the data? Recall from the
table that Middle East conflicts have
historically been associated with oilprice increases. It can reasonably be
argued that these conflicts were not
an immediate result of U.S. economic
conditions. That is, the overall state of
the U.S. economy at the time did not
influence the unfolding of the Middle
East conflicts and the associated rise
in oil prices listed in the table. Hamilton has argued that these conflicts can
indeed be thought of as external to the
U.S. economy, and so they can be used
to measure a causal effect of oil-price
shocks on output growth. Statistical
analysis that examines the effect of
these external episodes that led to
oil-price increases finds that these episodes do precede economic slowdowns.
This evidence argues that oil-price increases cause slower output growth.

Of course, there are many more
oil-price increases in the data than just
the five or so associated with Middle
East conflicts. Researchers have used
a variety of methods to isolate the important oil-price changes for predicting
real output growth. One early method
was to use only oil-price increases in
statistical analyses and ignore oil-price
decreases. However, researchers have
subsequently found that more sophisticated measures of oil-price increases
have a more stable relationship with
real output growth. In particular, a
measure of the net increase in oil price is
often used. This series is constructed
as follows: Compare oil prices in the
current period with the highest oil
price over a previous period, say, the
last 36 months. If the current price is
higher than the preceding 36-month
peak, calculate the percentage difference between the two. If the current
price is lower than the preceding 36month peak, set the series to zero. This
measure of net oil-price increases, in
effect, says that if the current price of
oil is increasing only because it is moving back up to a previous peak (over
the last three years), we don’t expect
it to have an effect on real output
growth. However, if the current price
is higher than it has been over the last
three years, we can expect an effect on
real output growth.10
Figure 4 shows that the net increase in oil prices, measured quarterly,
tends to rise significantly before U.S.
recessions, and this series does a good
job of picking up the price movements
associated with the Middle East conflicts reported in the table.11 Note that

8
See the two articles by James Hamilton. Hamilton’s 2003 article contains many references
to the literature on quantifying the effect of oil
shocks on the U.S. economy.

10
In his 2004 article, Hamilton argues that the
net oil-price increase over a 36-month period
has good statistical properties and summarizes
well a complicated nonlinear link between oil
prices and real output growth.

9
By external we mean events that are not
caused by U.S. economic conditions. Economists use the term exogenous to describe such
external events.

26 Q1 2007 Business Review

11

The quarterly measure of a net oil-price
increase is constructed by averaging the
monthly net oil-price increase series.

this series is quite often zero. In fact,
from the early 1950s until the end of
2004, there are about 700 months of
data. But in only about 75 of those
months is the net oil-price increase
positive; the rest of the time it is zero.
By this measure, oil shocks are fairly
infrequent events. In his 2004 article, Hamilton demonstrates that net
oil-price increases basically capture
the historical tendency of the U.S.
economy to do poorly after the five
major Middle East conflicts listed in
the table.
So far, we have talked about the
effect of oil prices on the economy.
However, we could alternatively look
directly at the quantity of oil produced
each year and ask how changes in the
world supply of oil affect the economy.
Lutz Kilian, in a 2006 working paper,
did just that. He examined data on
the quantity of oil produced by the
world’s suppliers, focusing principally
on suppliers from the Middle East. To
develop a series of data on the effects
of external shocks on oil quantities,
Kilian posed the question of what oil
production would have been had a
country not experienced a conflict
such as a war. The difference between
the amount of oil a country would
have produced had there been no
conflict and the quantity that was
produced during the conflict gives
a measure of supply shortfall that is
external to developments in the U.S.
economy (Figure 5). The Middle East
supply disruptions listed in the table
show up as large downward movements
in the quantity of oil. As with the net
oil-price series, we see that dramatic
movements in the series preceded U.S.
recessions. In this case, it is a dramatic
falloff in the supply of oil. Interestingly,
note that there is no sharp falloff in
supply that helps explain the dramatic
post-1999 increase in the price of oil.
This suggests that the latest upward
movement in the price of oil is a con-

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sequence of growth in demand for oil
outpacing growth in supply.

FIGURE 4
Net Oil-Price Increase
Percent
0.5
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05

Source:

Jan-05

Jan-03

Jan-01

Jan-99

Jan-97

Jan-95

Jan-93

Jan-91

Jan-89

Jan-85

Jan-87

Jan-83

Jan-81

Jan-79

Jan-77

Jan-75

Jan-73

Jan-71

Jan-69

Jan-67

Jan-65

Jan-63

Jan-61

Jan-59

Jan-57

Jan-55

Jan-53

Jan-51

Jan-49

0

Author’s calculations

FIGURE 5
Exogenous Oil Supply Shocks
Percent
4

2

EMPIRICAL EVIDENCE
ON HOW MUCH OIL
SHOCKS MATTER
The evidence presented so far
indicates that oil shocks, in the form
of higher oil prices or reduced supplies
of the quantity of oil, have a negative
effect on U.S. real output growth. How
strong is this negative relationship? We
can use statistical analysis to estimate
how much an increase in the price of
oil caused by external factors reduces
real output growth.
The effect of oil-price shocks
caused by external factors on real
output growth can be measured by
running a statistical analysis (called a
regression) of real output growth on
lagged real output growth and lags
of the net oil-price increase. The estimated regression is described more
fully in Quantifying the Effect of OilPrice Shocks. We can estimate this
regression and get meaningful results
because Hamilton's measure of net oilprice increases has been shown to be
a good proxy for changes in oil price
caused by external factors.12 Thus, we
don’t have to worry so much about
feedback from the U.S. economy to the
increase in net oil prices when interpreting the results.13

0
12
See, for example, the 2003 paper by James
Hamilton and the 2006 paper by Lutz Kilian.

-2

-4

-6

Source:

Lutz Kilian’s web page at http://www-personal.umich.edu/~lkilian/

www.philadelphiafed.org

Jan-02
Jan-03
Jan-04

Jan-98
Jan-99
Jan-00
Jan-01

Jan-97

Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96

Jan-88
Jan-89
Jan-90

Jan-85
Jan-86
Jan-87

Jan-81
Jan-82
Jan-83
Jan-84

Jan-78
Jan-79
Jan-80

Jan-73
Jan-74
Jan-75
Jan-76
Jan-77

Jan-71
Jan-72

-8

13
While oil prices spike prior to U.S. recessions,
interest rates also spike prior to recessions.
Thus, in their study, Ben Bernanke, Mark
Gertler, and Mark Watson conjecture that it
is really monetary policy responding to oilprice shocks that causes recessions, since their
model implies that an alternative policy could
have greatly mitigated the effect of oil shocks.
However, the article by James Hamilton and
Ana Maria Herrera and my article with Sylvain
Leduc argue that it is unlikely that alternative
monetary policies would have completely
avoided recessions in the face of the historical
oil shocks that hit the U.S. economy. See also
the Business Review article by Sylvain Leduc.

Business Review Q1 2007 27

Quantifying the Effects of Oil-Price Shocks
he dynamic effect of an exogenous oil shock on real output growth can be analyzed by running a
regression of real output growth on its own lags and lags of the oil-shock measure. A key to interpreting
the regression is that the oil-shock measure is exogenous, which means it is not itself influenced by
real output growth. To measure exogenous oil shocks, we use the measure of net oil-price increases
discussed in the text. This measure is calculated as the greater of zero and the percentage difference of
the current oil price from its previous 36-month peak. To measure real output growth, we use real GDP.
The regression uses quarterly data and is estimated over the period 1948:4 to 2005:4. To capture the dynamics of the
relationship, we included four lags of output growth and the net oil-price increase. The regression takes the form:

T

yt

yt-1

yt-2+ yt-3+ yt-4+ ot-1+ ot-2+ ot-3+ ot-4

where yt is quarterly real GDP growth at time t and ot is the net oil-price increase in quarter t.
The equation can be estimated by ordinary least squares. The estimated coefficients, t-statistics, and probabilities
that the coefficients are zero are:

Estimate

0.01

0.25

0.10

-0.10

-0.12

-0.02

-0.04

-0.02

-0.04

t-stat

7.54

3.74

1.39

-1.48

-1.90

-0.99

-2.20

-1.18

-2.41

Prob

0.00

0.00

0.16

0.13

0.06

0.32

0.03

0.23

0.01

The regression results indicate that the coefficients on the net oil-price increase are negative and statistically significant
at lags two and four and that the maximal impact of the oil shock occurs at lag four (when using three decimal places).
We can test whether the oil shocks have joint significance in the regression, which is a test of whether, statistically, we
get just as good a fit if the oil shocks are dropped. When we test that hypothesis, it is strongly rejected, which means that
oil-price increases have predictive power for real GDP growth.
A similar regression of headline CPI inflation on the net oil-price increase gives the following estimates:

Estimate

0.66

0.65

-0.02

0.39

-0.19

2.61

5.09

2.88

-4.64

t-stat

3.22

9.45

-0.37

5.17

-2.90

0.71

1.37

0.77

-1.25

Prob

0.00

0.00

0.71

0.00

0.00

0.48

0.17

0.44

0.21

The coefficient estimates on the net oil-price increase variable are not significantly different from zero, which indicates
that oil shocks are not helping to explain the path of inflation. Indeed, a formal statistical test of whether the net oilprice increase variable helps predict CPI inflation finds that it does not.

28 Q1 2007 Business Review

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The analysis indicates that the
largest effect of an oil-price shock
occurs about four quarters after the
shock, indicating that it takes some
time for the maximal effect of an oil
shock to hit the economy. The implied
path of an oil shock on real output
growth can be calculated using an
impulse response function. This type of
graph shows how real output growth
responds over time to a one-time
increase in the price of oil caused by
external factors. More specifically, this
type of graph can tell us how much
real output growth rises or falls over
time in response to a temporary 10
percent increase in the net price of oil
that lasts only one period. In our case,
we use quarterly data to estimate the
regression and generate the impulse
response. We can see how much real
output growth is affected an arbitrary
number of quarters in the future, given
a one-quarter increase in the net price
of oil today (Figure 6).
Figure 6 shows that an increase
in the net price of oil leads to a drop
in real output growth that gradually
increases over time until it reaches a
maximum four quarters after the shock
hits. After that, the growth rate of real
output gradually recovers, so that after
about three years, the effect of the oil
shock has largely worn off and real
output growth is back on its trend path
(in the figure, the trend growth rate
of real output has been removed). The
impulse response function indicates
that a 10 percent increase in the price
of oil results in real output growth
falling 0.55 percent at its maximum
impact. This translates into about a
1.4 percent permanent reduction in
the level of real output. Even a modest
external increase in the net price of oil
has a significant impact on real output,
according to our analysis.
A similar analysis can be performed to investigate the effect of
oil-price shocks on CPI inflation. The

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FIGURE 6
Real Output Response to Increase in Oil Prices
Real output growth response to 10% increase in net oil price
Percent
0.2
0
-0.2
-0.4
-0.6
0

5

15

10

20

25

Quarters After Shock

Real output level response to 10% increase in net oil price
Percent
0
-0.5
-1
-1.5
-2
0

5

10

15

25

20

30

35

40

Quarters After Shock

results from that regression are also
reported in the box on page 28. In
this case, though, it turns out that
oil-price shocks do not have a statistically significant effect on inflation. In
the context of our analysis, this means
that a jump in oil prices does not help
predict the path of future CPI inflation. It appears then that net oil-price
increases affect real output growth and
not inflation.
We can also examine how
changes in the quantity of oil caused
by external factors affect output
growth and inflation using the data
series put together by Lutz Kilian.
Recall that Kilian developed a series
of external shocks to oil quantity
that measure supply disruptions in

the Middle East. Kilian's analysis
indicates that a 10 percent decrease
in the oil supply caused by external
factors (which is about the magnitude
of the disruptions documented in
the table) leads to about a 2 percent
drop in real GDP growth about five
quarters after the shock hits. Kilian
also investigated the effect of external
oil-supply disruptions on CPI inflation.
His analysis indicates that the effect
on CPI inflation is negligible. Inflation
is up only about 0.75 percent three
quarters after the shock hits (which is
the maximal impact of oil shocks on
inflation).
The data on both oil-price
shocks and oil-quantity shocks give a
similar impression of what happens to

Business Review Q1 2007 29

the economy after an oil shock that
reduces supply and raises the price of
oil. Real output declines steadily for
several quarters, reaching a maximum
decline about one year after the shock
hits. Output then recovers gradually,
and after a few years, the shock has
largely worn off. Oil shocks appear
to have little if any effect on CPI
inflation.
THE INTERNATIONAL
PERSPECTIVE
Is the U.S. unique in its response
to oil shocks, or do other developed
countries display similar behavior? A
2005 working paper by Lutz Kilian examines this question using data on real
output growth, inflation, and his series
on external oil production shocks.
The sample of countries investigated
includes the United States, the United
Kingdom, Japan, Germany, Italy, Canada, and France.14
Using regressions similar to those
reported in Quantifying the Effect of
Oil-Price Shocks, Kilian finds a fair
degree of similarity in the real output
response of G7 countries to negative
oil production shocks. A 10 percent
external disruption in oil supply typically leads to about a 2 percent reduction in real output growth that occurs
between one and two years after the
shock hits. The weakest response
among the G7 countries is in Japan,
but when the data are analyzed on the
basis of cumulative inflation and real
growth responses, Italy and France also
have fared well historically when confronted with oil supply shocks.
For inflation, Kilian finds that oil
supply disruptions do not lead to sustained inflation in the G7 countries.
There is some evidence for stagflation
(a simultaneous rise in inflation and

14
These countries are known as the Group of 7,
or the G7.

30 Q1 2007 Business Review

FIGURE 7
World Oil Demand
Barrels / Day (000s)
25,000

Asia & Oceania
20,000

United States

Western Europe

15,000

10,000

Eastern Europe & Former U.S.S.R.
5,000

0
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Source:

Energy Information Administration

fall in real output growth) for the U.S.,
the U.K., and Italy. There is no such
evidence for stagflation in response
to oil shocks for Germany, Japan, and
Canada.
Thus, the evidence from other
developed countries is broadly similar
to what we have described for the U.S.
Oil shocks caused by external factors
that lower supply and raise price do
appear to have a negative effect on real
output growth. The evidence for oil
shocks’ effects on inflation is more varied, but it is largely consistent with the
view that oil shocks do not have strong
inflation effects.
Recent Developments. The principal reason for recent increases in the
price of oil is strong world demand as
developing countries increase their
oil consumption (Figure 7). What is
striking about the figure is the recent
strength in demand for oil coming
from Asian countries. Principally, this
demand growth is from China, India,
and Indonesia. As these countries
become wealthier, their demand for

goods such as automobiles is rising,
which leads to increased oil consumption. Note as well that U.S. demand
has been strong recently as the economy has experienced strong real output
growth.
Interestingly enough, strong demand for oil from regions of the world
such as Asia can, from the perspective
of the U.S., look very similar to an oilprice shock. To the extent that trade
ties between the U.S. and Asia are
weak, strong growth or weak growth
in the U.S. may have little effect on
economic growth in Asia. Consequently, Asian demand for oil that
boosts the worldwide price of oil, and
hence the price the U.S. pays for oil,
is external to U.S. economic conditions and so may be no different from a
conflict in the Middle East that results
in a higher price for oil. In the case
of the post-1999 oil-price increases,
though, the rise in price has been fairly
gradual compared with the external
price increases we have talked about.
Consumers and firms have had time to

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adjust to the price increase and, given
the strength of the U.S. economy, certainly part of the oil-price increase has
been due to strong U.S. demand for oil.
As a consequence, the effect on the
economy of the most recent rise in the
price of oil may not be as strong as predicted based on the periods of Middle
East crises.
Nonetheless, we can conduct a
back-of-the-envelope simulation using
the estimated relationship between
real output and net oil-price increases
that generated the impulse responses
in Figure 6. If we simulate the model
using the net oil-price increases that
occurred between 2004Q1 through
2006Q2, the prediction is that the
level of real GDP (holding all else constant) is currently about 3.2 percent
lower than what it would have been
had there been no oil shocks over that
period.

CONCLUSION
Historically, the U.S. economy
has tended to perform poorly following major disruptions in the supply of
oil that coincide with large increases
in the price of oil. Typically, these
disruptions have been associated with
conflicts in the Middle East that significantly affected the world supply of
oil. The nature of these conflicts is
that they are external to developments
in the U.S. economy. Consequently,
these episodes provide evidence that
oil-price increases may directly cause
slower real output growth, both for the
U.S. and for the other major industrial
countries.
The empirical evidence suggests
that a 10 percent increase in the price
of oil is associated with about a 1.4 percent drop in the level of U.S. real GDP.
Interestingly, increases in oil prices
have no significant effect on U.S. in-

flation, a finding that largely holds up
when we look at the major industrial
economies.
Since 1999, there has been a dramatic increase in the world price of oil.
The evidence suggests that this increase is driven not so much by supply
disruptions as by strong demand from
the U.S., Western Europe, and Asia,
especially China, India, and Indonesia.
From the perspective of the U.S., some
of this price increase is tantamount
to an external oil shock. However,
because the rise in price has been
gradual and has occurred in the face of
strong growth, the U.S. economy has
not experienced an oil-induced recession. Nevertheless, the evidence suggests that the recent rise in oil prices
has worked to restrain domestic output
growth. BR

Hamilton, James D., and Ana Maria
Herrera. “Oil Shocks and Aggregate
Macroeconomic Behavior: The Role of
Monetary Policy: Comment,” Journal of
Money, Credit, and Banking, 36 (2004),
pp. 265-86.

Leduc, Sylvain. “Oil Prices Strike
Back,” Federal Reserve Bank of
Philadelphia Business Review (First
Quarter, 2002), pp. 21-30.

REFERENCES
Bernanke, Ben, Mark Gertler, and
Mark Watson. “Systematic Monetary
Policy and the Effects of Oil Price
Shocks,” Brookings Papers on Economic
Activity, 1 (1997), pp. 91-142.
Davis, Steven, and John Haltiwanger.
“The Sectoral Job Creation and
Destruction Responses to Oil Price
Changes,” Journal of Monetary
Economics, 48 (2001), pp. 465-512
Hamilton, James D. “Oil and the
Macroeconomy Since World War II,”
Journal of Political Economy, 91 (1983),
pp. 228-48.
Hamilton, James D. (2003), “What Is
an Oil Shock?” Journal of Econometrics,
13 (2003), pp. 363-98.

www.philadelphiafed.org

Kilian, Lutz. “The Effects of
Exogenous Oil Supply Shocks on
Output and Inflation: Evidence from
the G7 Countries,” Working Paper,
University of Michigan (2005).

Leduc, Sylvain, and Keith Sill. “A
Quantitative Analysis of Oil Price
Shocks, Systematic Monetary Policy,
and Economic Downturns,” Journal
of Monetary Economics, 51, (2004),
pp. 781-808.

Kilian, Lutz. “Exogenous Oil Supply
Shocks: How Big Are They and How
Much Do They Matter for the U.S.
Economy?” Working Paper, University
of Michigan (2006).

Business Review Q1 2007 31

RESEARCH RAP

Abstracts of
research papers
produced by the
economists at
the Philadelphia
Fed

You can find more Research Rap abstracts on our website at: www.philadelphiafed.org/econ/resrap/index.
html. Or view our Working Papers at: www.philadelphiafed.org/econ/wps/index.html.
AGGLOMERATION ECONOMIES AND
THE SPATIAL CONCENTRATION OF
EMPLOYMENT
This paper seeks to quantify the contribution of agglomeration economies to the spatial
concentration of U.S. employment. A spatial
macroeconomic model with heterogeneous
localities and agglomeration economies is developed and calibrated to U.S. data on the spatial
distribution of employment. The model is used
to answer the question: By how much would the
spatial concentration of employment decline if
agglomeration economies were counterfactually
suppressed? For the most plausible calibration,
the answer is about 48 percent. More generally,
the general equilibrium contribution of agglomeration economies appears to be substantial,
with empirically defensible calibrations yielding
estimates between 40 and 60 percent.
Working Paper 06-20, “A Quantitative Assessment of the Role of Agglomeration Economies
in the Spatial Concentration of U.S. Employment,”
Satyajit Chatterjee, Federal Reserve Bank of
Philadelphia
HOW DO ENFORCEMENT COSTS
AFFECT THE OWN VS. LEASE
DECISION?
The authors develop a legal contract
enforcement theory of the own versus lease
decision. The allocation of ownership rights
will minimize enforcement costs when the legal
system is inefficient. In particular, when legal
enforcement of contracts is costly, there will be
a shift from arrangements that rely on such enforcement (such as a rental agreement) toward
other forms that do not (such as direct ownership). The authors then test this prediction and
show that costly enforcement of rental contracts
hampers the development of the rental housing market in a cross-section of countries. They
argue that this association is not the result of
32 Q1 2007 Business Review

reverse causation from a developed rental market
to more investor-protective enforcement and is
not driven by alternative institutional channels.
The results provide supportive evidence on the
importance of legal contract enforcement for
market development and the optimal allocation of
property rights.
Working Paper 06-21, “Owning Versus Leasing:
Do Courts Matter?,” Pablo Casas-Arce, Universitat
Pompeu Fabra, and Albert Saiz, University of Pennsylvania, and Visiting Scholar, Federal Reserve Bank
of Philadelphia
IMMIGRATION AND NEIGHBORHOOD
DYNAMICS
What impact does immigration have on
neighborhood dynamics? Within metropolitan
areas, the authors find that housing values have
grown relatively more slowly in neighborhoods
of immigrant settlement. They propose three
nonexclusive explanations: changes in housing
quality, reverse causality, or the hypothesis that
natives find immigrant neighbors relatively less
attractive (native flight). To instrument for the
actual number of new immigrants, the authors
deploy a geographic diffusion model that predicts
the number of new immigrants in a neighborhood
using lagged densities of the foreign-born in surrounding neighborhoods. Subject to the validity
of their instruments, the evidence is consistent
with a causal interpretation of an impact from
growing immigration density to native flight
and relatively slower housing price appreciation.
Further evidence indicates that these results may
be driven more by the demand for residential
segregation based on race and education than by
foreignness per se.
Working Paper 06-22, “Immigration and
the Neighborhood,” Albert Saiz, University of
Pennsylvania, and Visiting Scholar, Federal Reserve
Bank of Philadelphia, and Susan Wachter, University
of Pennsylvania
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