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Monday, May 26, 2008

"The US Dollar Hits an Oil Slick"

Martin Feldstein says to expect more rapid dollar depreciation in coming years:

The US dollar hits an oil slick, by Martin Feldstein, Project Syndicate [alt]: The rapid rise in the price of oil and the sharp depreciation of the dollar are two of the most noteworthy developments of the past year. ... To many observers, the combination of a falling dollar and a rise in oil prices appears to be more than a coincidence.

But what is the link between the two? Would the price of oil have increased less if oil were priced in euros instead of dollars? Did the dollars fall cause the price of oil to rise? And how did the rise in the price of oil affect the dollars movement? ...

The thinking behind the question of whether oil would cost less today if it were priced in euros seems to be that, since the dollar has fallen relative to the euro, this would have contained the rise in the price of oil.

In reality, the currency in which oil is priced would have no significant or sustained effect on the price of oil when translated into dollars, euros, yen, or any other currency.

Here is why. The market is now in equilibrium with the price of oil at US$120. That translates into 75 euros at the current exchange rate of around US$1.60 per euro. If it were agreed that oil would instead be priced in euros, the quoted market-equilibrating price would still be 75 euros and therefore US$120. ...

Of course, the rate of increase of the price of oil in euros during the past year was lower than the rate of increase in dollars. ... But that would be true even if oil had been priced in euros. ...

The key point here is that the euro price of oil would be the same as it is today. ... The only effect of the dollars decline is to change the price in dollars relative to the price in euros and other currencies.

The high and rising price of oil does, however, contribute to the decline of the dollar, because the increasing cost of oil imports widens the US trade deficit. ...

The dollar is declining because only a more competitive dollar can shrink the US trade deficit to a sustainable level.

Thus, as rising global demand pushes oil prices higher in the years ahead, it will become more difficult to shrink the US trade deficit, inducing more rapid dollar depreciation.

    Posted by on Monday, May 26, 2008 at 02:16 PM in Economics, International Finance | Permalink  TrackBack (0)  Comments (8)


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