Stepping on a Rake II: OPEC's Influence on Oil Prices and U.S. Inflation in the 1970s

Abstract

This paper makes three contributions. First, it presents new data disfavoring the hypothesis that the first oil price shock was principally caused by global de- mand. Second, it describes a model of the oil exporting behavior of a dominant producer in which behavior depends on the location of discontinuities in the step-wise price function relative to current demand, the expected, real interest rate on the liquid asset, and the supply of high yield, illiquid assets. Third, it proposes a feedback loop between oil prices and inflation that was driven by OPEC pricing and investment behavior, and that can account for the strong, correlation between oil prices and inflation in the 1970s despite the small share of oil in total U.S. output.