Do Gas Prices Make a Difference?

A study released today by the Travel Industry Association of America indicates that Americans plan more summer travel than last year. Some media outlets are misinterpreting this as evidence that high gas prices may affect travel less than some people have expected. The reason that it’s a faulty inference, of course, is that really one should compare how much people travel this year with high gas prices with how much they would have traveled this year with lower gas prices, not with how much they traveled last year.

Nevertheless, I find it moderately plausible that people’s driving plans have not yet changed much due to higher gas prices. Does this mean that higher oil prices won’t have much of an effect on the economy?

Not necessarily. The main way in which higher oil prices affect the economy is not by shortening summer road trips. More important are the effects of higher oil prices on energy inputs to firms, and the possible broader inflationary effects that this has on the economy. Higher interest rates result, which impose their own drag on the economy. These negative effects on the economy are not nearly as great as they were 20 years ago, but they still exist. (See this nice primer from the Dallas Fed for more about this.)

One interesting theoretical note: if you think about it, it is not immediately clear that higher oil prices should lead to higher inflation in general. In a world of smoothly-adjusting markets and prices, then when the price of one type of good rises, we would expect the prices of other types of goods to fall. In other words, a rise in the price of oil is just a rise in one particular relative price. All we should expect is to see the price of energy-intensive goods rise relative to the price of non-energy-intensive goods. However, we do in fact see a positive relationship between oil prices and inflation more generally. This therefore constitutes indirect evidence that prices do not in fact adjust freely in our economy. As Keynes famously pointed out 70 years ago (and many others less famously), prices are sticky.

The bottom line: while summer travel plans may not be noticeably curtailed, I still expect to see some summer slowdown in the economy as a result of recent oil prices.