The Impact of Energy Price Shocks on Capital Formation and Economic Growth in a Putty-Clay Technology

Abstract

Since the OPEC price increases of 1973 and 1979, a number of studies have examined the impact of higher energy prices on labor productivity, investment, and the capital stock [2; 3; 7; 12; 13; 14]. One of the goals of this research has been to assess the contribution of energy price shocks to the slowdown in long-term economic growth that occurred in the 1970s and early 1980s. This is an important question because, in the long run, growth in labor productivity is the principal determinant of increases in the standard of living, and over shorter periods of time, the level of potential output is a major constraint on the conduct of monetary and fiscal policy. Energy is an attractive explanation for the slowdown because the timing appears to be correct and the worldwide nature of the problem argues against other theories which are country specific. Many different types of models have been developed to address these questions but most assume a putty-putty production technology in which capital is homogeneous and malleable. This causes the economy to adjust rapidly to an increase in energy prices, both in the size of the capital stock and in its associated labor and energy requirements. However, such an assumption is inappropriate. In reality, the capital stock cannot be instantaneously transformed after an energy price increase, and to assume so seriously overstates the speed with which the economy can adapt to the new set of relative prices. A more realistic assumption is that the production technology is putty clay. Factor intensities can be adjusted ex ante according to a smooth neoclassical production function, but ex post no substitution is possible. Firms adjust to a change in relative prices on their new capacity, but all old vintages must be replaced before adjustment is complete. Although the puttyputty and putty-clay models eventually achieve the same long-run equilibrium, their paths to the new steady state are very different. The putty-putty model jumps immediately to the new