The Dollar Hits an Oil Slick

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 for energy pushes oil prices higher in the years ahead, it will become more difficult to shrink America’s trade deficit, inducing more rapid dollar depreciation.

CAMBRIDGE – 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. The price of oil has increased by 85% over the past 12 months, from $65 a barrel to $120. During the same period, the dollar fell by 15% relative to the euro and 12% against the yen. 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 dollar’s fall cause the price of oil to rise? And how did the rise in the price of oil affect the dollar’s movement?

Because the oil market is global, with its price in different places virtually identical, the price reflects both total world demand for oil and total supply by all of the oil-producing countries. The primary demand for oil is as a transport fuel, with lesser amounts used for heating, energy, and as inputs for petrochemical industries like plastics. The increasing demand for oil from all countries, but particularly from rapidly growing emerging-market countries like China and India, has therefore been, and will continue to be, an important force pushing up the global price. 

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