# Oil Shocks and Stagflation

Business I · Economic History · https://tryals.app/learn/business-i/oil-shocks-and-stagflation

## The End of Cheap Energy

The **oil shock of 1973** ended the postwar Golden Age. When OPEC embargoed oil, the price quadrupled from 3 to 12 dollars a barrel, followed by a 1979 shock above 35 dollars. 

**Stagflation** is the simultaneous occurrence of economic stagnation and rising inflation. It broke the **Phillips curve**, which assumed an inverse trade-off between unemployment and inflation. 

$$\text{Demand shock: } \Delta \text{ inflation and } \Delta \text{ unemployment move oppositely}$$
$$\text{Supply shock: } \Delta \text{ they move together}$$

As a **supply-side shock**, higher oil costs pushed prices up while reducing output, defeating standard Keynesian demand tools. Stimulating demand during an oil shortage buys more inflation, not output.

## Breaking Stagflation

**Paul Volcker** at the Fed in 1979 chose to crush inflation via extreme monetary tightening, raising interest rates above 20%. The **cost** was a severe 1981-82 recession, but inflation fell from 13% down to 3% and expectations anchored.

This sparked a broader 1980s policy rethink toward deregulation, privatization, and independent central banks focused strictly on price stability.

| Era | Keynesian consensus | Post-1979 |
| --- | --- | --- |
| Diagnosis | Demand management | Inflation is monetary |
| Tool | Fiscal fine-tuning | High rates, credibility |
| Casualty | Broke on stagflation | Deep 1980-82 recession |

**The structural legacy**: energy intensity—energy per unit of GDP—began a permanent decline as economies diversified into services and fuel efficiency.

## Practice questions

10 of this lesson's 14 practice questions, with answers. The full set is in the app.

### 1. Demand shock or supply shock?

**Answer:**

- Demand shock: Government increases spending during a boom, Central bank cuts interest rates to stimulate borrowing
- Supply shock: OPEC embargo quadruples oil prices, A drought destroys the wheat harvest

**Why:** Demand shocks shift spending (inflation and unemployment move oppositely). Supply shocks shift costs (they move together, the stagflation pattern).

Page: https://tryals.app/practice/business-i/oil-shocks-and-stagflation/demand-shock-or-supply-shock

### 2. Match each 1970s-80s concept to its meaning.

**Answer:**

- Stagflation → Stagnation plus inflation at the same time
- Volcker shock → Extreme rate hikes to crush inflation expectations
- Phillips curve → The inverse inflation-unemployment trade-off
- Supply-side economics → Focus on production incentives over demand management

**Why:** Four concepts that defined the end of one era and the beginning of another.

Page: https://tryals.app/practice/business-i/oil-shocks-and-stagflation/match-each-1970s-80s-concept-to-its-meaning

### 3. The standard Keynesian response to a downturn is to stimulate demand. Why did that fail after the 1973 oil shock?

A. Because the stimulus was too small to have any effect
B. Because Keynesian policy had already been abandoned by 1973
C. Because oil is priced in dollars, which neutralises domestic policy
D. Because the shock hit supply, not demand

**Answer:** D. Because the shock hit supply, not demand

**Why:** Demand management answers demand shocks. A supply shock raises prices and lowers output together, and more demand worsens the first without fixing the second, which is why Volcker eventually attacked the inflation instead.

Page: https://tryals.app/practice/business-i/oil-shocks-and-stagflation/the-standard-keynesian-response-to-a-downturn-is-to-stimulate-demand

### 4. Stagflation, high inflation with high unemployment, was supposed to be impossible under the Phillips curve. What did the 1970s reveal about the relationship?

A. That supply shocks are the only cause of inflation, making the curve irrelevant
B. That the Phillips curve was a statistical artefact with no underlying relationship
C. That the trade-off depends on expectations, which adjust
D. That the trade-off exists but is much weaker than 1960s estimates suggested

**Answer:** C. That the trade-off depends on expectations, which adjust

**Why:** A trade-off that depends on fooling people stops working once they stop being fooled, so the curve shifts up with expectations and the policy has to keep escalating. Friedman and Phelps predicted this before it occurred, one of macroeconomics' genuine out-of-sample successes, and it is why central banks now target expectations directly.

Page: https://tryals.app/practice/business-i/oil-shocks-and-stagflation/stagflation-high-inflation-with-high-unemployment-was-supposed-to

### 5. Volcker raised interest rates above 20% in 1980-81. The immediate result was:

A. A severe recession
B. Oil prices fell immediately
C. Economic growth surged
D. Inflation accelerated further

**Answer:** A. A severe recession

**Why:** The Volcker disinflation worked but at the cost of the deepest postwar recession (to that date). The lesson: inflation expectations, once anchored high, require pain to break, but once broken, they stay down.

Page: https://tryals.app/practice/business-i/oil-shocks-and-stagflation/volcker-raised-interest-rates-above-20-in-1980-81-the-immediate

### 6. Which policy shifts characterised the post-stagflation era?

A. A return to the gold standard
B. Deregulation and privatisation
C. Shift from fiscal to monetary policy as the primary tool
D. Independent central banks focused on price stability

**Answer:** B. Deregulation and privatisation; C. Shift from fiscal to monetary policy as the primary tool; D. Independent central banks focused on price stability

**Why:** Central bank independence, deregulation, and monetary primacy, the 1980s consensus. Gold was not restored.

Page: https://tryals.app/practice/business-i/oil-shocks-and-stagflation/which-policy-shifts-characterised-the-post-stagflation-era

### 7. Order the 1970s-80s macro events.

**Answer:**

1. First oil shock. OPEC embargo (1973)
2. Stagflation spreads across the West
3. Second oil shock. Iranian Revolution (1979)
4. Volcker raises rates above 20% (1980-81)
5. Inflation falls, recovery begins (1983)

**Why:** Two shocks, a decade of stagflation, then the Volcker cure, painful but effective.

Page: https://tryals.app/practice/business-i/oil-shocks-and-stagflation/order-the-1970s-80s-macro-events

### 8. A supply shock like an oil embargo shifts the Phillips curve outward, so both inflation and unemployment can rise together.

**Answer:** True

**Why:** The Phillips curve shifts with supply shocks: higher costs mean higher inflation at every level of unemployment. The demand-side trade-off still exists, but it operates on a worse frontier.

Page: https://tryals.app/practice/business-i/oil-shocks-and-stagflation/a-supply-shock-like-an-oil-embargo-shifts-the-phillips-curve-outward

### 9. Oil went from 3 to 12 dollars in 1973. Express the percentage increase.

**Answer:** 300

**Why:** $(12 - 3) / 3 \times 100 = 300\%$. A 300% price increase in a universal input is an economy-wide cost shock.

Page: https://tryals.app/practice/business-i/oil-shocks-and-stagflation/oil-went-from-3-to-12-dollars-in-1973-express-the-percentage

### 10. Stagflation combined high inflation with high unemployment, which the Phillips curve said could not persist. Why was that a crisis for the theory and not just a bad decade?

A. Because inflation and unemployment had never risen together before
B. Because the oil shocks were external and no theory covers external shocks
C. Because the curve had been derived from data for a single country
D. Because the trade-off shifted once expectations adjusted

**Answer:** D. Because the trade-off shifted once expectations adjusted

**Why:** This is the Lucas critique in the wild: a correlation exploited by policy stops holding, because the behaviour producing it adapts to the policy.

Page: https://tryals.app/practice/business-i/oil-shocks-and-stagflation/stagflation-combined-high-inflation-with-high-unemployment-which-the