Oil Shocks and Stagflation

The End of Cheap Energy

The oil shock of 1973 ended the Golden Age. When OPEC embargoed oil during the Yom Kippur War, the price quadrupled from roughly 3 to 12 dollars per barrel. A second shock in 1979 (Iranian Revolution) pushed it above 35. The era of cheap energy was over — and with it, the postwar bargain.

Stagflation — simultaneous stagnation and inflation — was the monster the Keynesian toolkit was not built for:

• Supply-side shock: oil is an input to almost everything. A price spike raises costs across the economy (cost-push inflation) while reducing output (the real economy contracts). The result: prices up, output down — both at once.
• The Phillips curve broke: the postwar consensus assumed a stable trade-off between inflation and unemployment — stimulate to reduce unemployment, accept higher inflation, and vice versa. Stagflation showed that both could rise together when the shock came from supply, not demand.

$$\text{Demand shock: inflation and unemployment move oppositely}$$ $$\text{Supply shock: they move together, the Phillips curve shifts}$$

Policy response (eventually): the Keynesian demand-management approach lost credibility. Paul Volcker at the Fed (1979) chose to crush inflation with extreme monetary tightening — raising interest rates above 20%. The result: a severe recession (1981-82), but inflation fell from 13% to 3%. The pain bought credibility, and inflation expectations anchored.

The broader policy rethink of the 1980s: deregulation, privatisation, supply-side economics (Thatcher in the UK, Reagan in the US), independent central banks focused on price stability, and a shift from fiscal to monetary policy as the primary macro tool. The mixed economy retreated; market-oriented policies advanced.

The structural legacy: energy intensity — the amount of energy per unit of GDP — began a long decline. Economies diversified away from oil-intensive industry; fuel efficiency improved; service sectors grew. The oil shocks forced an adaptation that permanently changed the relationship between energy and growth.

Two policy eras

Tip: Stagflation's lesson in one line: demand tools cannot fix a supply shock. Stimulating demand into an oil shortage buys more inflation, not more output — the diagnosis must precede the medicine.