METHODOLOGY
Both U.S. Dollar exchange rate and the oil price are foremost variables which coerce the progression of the world economy. Fluctuations in these variables profoundly affect international trade and economic activities in all the countries. Determination of the link between these key variables is one of the vital issues, whether they are correlated or not. Is there any empirical evidence on the link between the variables?
In this literature, I initiate by surveying all theoretical reasons that could elucidate the relationship between U.S. Dollar exchange rate and oil prices. To start with, as oil price and oil trade is denominated in United State's Dollars, movements in the effective exchange rate of U.S. Dollar affect the price of oil as alleged by all countries outside United States. Therefore, fluctuation in the dollar exchange rate can elicit changes in demand and supply of oil, which cause changes in the oil price. Secondly, the opposite trend can also be found, i.e., oil price fluctuation trigger changes in effective exchange rate. The reason can be found in the literatures on the effective exchange rates. In the model proposed by Farquee (1995), if a country stocks foreign assets, its effective exchange rate appreciates and this movement occurs without impeding its current account balances. This is due to the reason that capital income absorbs the loss in trade receipts induced by the deteriorated competitiveness. Change in oil price affects all the world imbalances and this induced change in international assets may have an impact on effective exchange rates of different countries of the world. Last but not the least, I take collection of different portfolio models, most importantly the ones by Golub (1983) and Krugman (1983a) which are developed to account for trade and financial interactions such as aid and grants between United States, oil producer countries and the rest of the world especially Europe.
The comprehensive survey of theoretical and empirical interactions between the two key variables opens the way for every possible link between the two variables either negative, positive and in both directions of causality. If there are some theoretical reasons for every possible link, then one has to be stronger than others. Therefore, the question is to unravel the alternative theoretical explanation by confronting to the data.
I therefore, conduct an empirical study of the relationship between dollar real effective exchange rate and the oil prices over the period straddling from 2007 to till date. Prime focus is on the long term relationship between these two vital variables. Among the possible explanation reviewed, the one involving the equilibrium exchange rate is the sole explanation which fit the found relationship. The possible continuation of a long-term relationship between the dollar effective exchange rate and oil price assume causality between these variables. Earlier studies show a causality direction from oil prices to the U.S. dollar (Amano and van Norden, 1995 among others). However, there are some arguments which justify opposite direction of causality i.e., from U.S dollar to the oil price. In this literature, I study the two types of causality and try to assess the resulting of the relationship which determines the trend of movement.
The effective dollar exchange rate has substantial impact on the demand and supply of oil since it had influence on the price of oil. The depreciation in the dollar reduces the price of oil in the local markets of the countries having their respective currencies under floating exchange rate like Japan or Euro Zone. The countries which have pegged their currency with the dollar have neutral affect such as China. Generally, a decrease in the dollar exchange rate reduces the oil price in the local markets of the consumer countries. The decrease in price of oil ultimately increases the demand for oil price. This can be stated that dollar depreciation has positive impact on demand for oil and this increase demand contributes towards the rise in the price of the oil.
Oil companies use local currencies of producer currencies to pay the financial liabilities and current financial obligations such as wages, taxes and other operating cost. These currencies are often linked or pegged to the dollar due to the fact that they fall in fixed-exchange rate regimes adopted by most producer countries (Frankel, 2003). The changes in price of oil due to the change in the dollar exchange rate is less as estimated by the producer countries than estimated by the demander or consumer countries. Necessary drilling activities are linked directly to the oil price. When oil price increase, oil production also increase by the producer countries to earn additional profits. This fact has been proved by different empirical studies in countries like North America, Latin American and Middle East. But this fact has not been proved true for African and European countries. It is important to that the relationship between drilling activities and oil price in dollars has substantially changed since 1999. But it is hard to find that whether this change occur due to the introduction of Euro currency in 1999 or due to the reduction in oil price in 1998.
Depreciation in the dollar price initiates inflation resulting reduction in the income of oil producer countries, the currencies which are pegged to the dollar. All the countries are not affected in the say way, countries which largely import from USA like OPEC is less affected than countries than countries which imports from Europe or Asia. Overall, depreciation in the dollar price may reduce the supply of oil.
On the short run, supply is less or weakly elastic to the price in upward and downward direction. The upward weak flexibility is due to the production constraint and the downward flexibility is weak due to very small marginal cost. Demand is also inelastic in the short run due to the lack of substitutes available in the short run (Carnot and Hagege, 2004). In short, demand and supply of oil in short is almost inelastic in the short run. Noticeable changes in the supply and demand are mainly observable on the long term period. At this stage supply is more elastic due to the capability of new investment and demand is more elastic due to the availability of close substitutes.
Generally, a dollar effective exchange rate depreciation cause an increase in the demand and supply of the oil significantly only in the long run, which tends to increase oil price. The early years of 2000's period are an excellent example of this mechanism. Hagege and Carnot (2004) underlined that the increase in oil prices stems from two concurrent factors on the one hand, wrong estimation of extreme demand for oil from United States and China. On the other hand, diminishing investment in the oil sector causes stagnation in the capacity enhancement of oil supply. If this mechanism of demand and supply can correctly explain the situation of 2000s then this mechanism is unable to account for the relationship found in different empirical studies.
There are several evidences and reasons to believe that oil price could affect dollar effective exchange rate. Most frequent explanation of this impact that oil producing countries prefer financial investment in dollars (Amano & van Norden, 1993 & 1995). This framework, explains that a rush in the oil price boot the wealth of the oil producer countries which in turn increase the demand for dollar. Another explanation of this impact of oil price on exchange rate can be found in the models such as Farguee (1995) and BEER model proposed by McDonald and Clark (1998). In this approach, two independent variables are frequently used for explaining the exchange rate i.e., net foreign investment and the terms of trade. A quick initial reasoning leads to a negative relation between oil price and the dollar exchange rate. Increase in oil price should deteriorate the United States terms of trade which results in the dollar price depreciation. A more comprehensive explanation would allow explaining the positive relationship usually found in the literature by taking in account the relative effect on the United States compared to its trade partners. If United States is an important oil importer, an oil price increase can deteriorate its situation, however, if US import less than some other countries like Japan or Euro zone, its position may well improve compared to the other countries. In this situation, increase in the oil price would lead to the appreciation in the dollar price relatively to the yen and the euro, eventually it leads to appreciation in effective terms in dollar.
In an approach proposed by Krugman (1983a) uses a vibrant symmetry of framework to model how producer countries use the revenue of their oil exports in dollars. Change in demand for dollar will affect the dollar exchange rate. The proposed model can be expressed mathematically as:
X = CY
Where X = Oil price denominated in dollar
Y = Effective exchange rate of dollar
C = Correlation Co-efficient
This models help to determine the correlation between the oil price and the effective dollar exchange rate, either it is positive, negative or neutral. This model also explains the short term and long term impact of oil price on the effective exchange rate of the dollar and vice versa.
This empirical study use monthly data of oil price denominated in the U.S dollar. Oil prices are expressed in real terms and the exchange rate of dollar is effective exchange rate. This study tests the hypothesis at 5% level of significance. Hypothesis to be tested is as follows:
Ho = There is a no correlation between the oil price and effective exchange rate of dollar
H1 = There is a correlation between the two variables.
Ho = There is a negative correlation between the two variables
H1 = There is positive correlation between the oil price and effective exchange rate
Above hypothesis are tested by Spearman rank correlation using SPSS, renowned statistical software. Data for this variable is collected through different sources such as Central Bank of Germany, Data Stream and Economagic which maintain the monthly average data of oil price, effective exchange rate and international gold prices. Sample size is of 42 values from each category. Oil prices and gold prices are denominated in the US dollar. Apparent observation of the raw data indicates the positive relation between oil price and effective dollar exchange rate.
TESTING
The testing of the hypothesis is done through SPSS v.16. Econometric technique of Spearman Rank Correlation is applied as it falls in the classification of non-parametric test. The table below summarizes the results:
Particulars
Exchange Rate
Oil Price
Oil Price
0.316
1
Exchange Rate
1
0.316
The results of econometric analysis shows that there is a medium positive correlation between the oil price and effective exchange rate of dollar as co-efficient of correlation is 0.316 which means that 1 dollar or 1 percent increase in oil price will increase 0.316 % in the effective dollar exchange rate. The oil prices show more variability as compared to the exchange rate. The graphical presentation of the original data is as follows:
Graphical Presentation of Oil Price and Exchange Rate
Above graph shows a general positive trend between the two variables over the period spanning from January 2007 to October 2010. The graph also reveals greater variability in the oil price and less in the exchange rate. The variables are assigned as OP referred to oil price and ER referred to effective exchange rate of US dollar.
For further analysis we extend the study including the international gold rate in our model which provides results as follows:
Particulars
Oil Price
Gold Rate
Oil Price
1
-0.055
Gold Rate
-0.055
1
The tabulated results show that there is a slightly negative correlation between the oil price and gold rate. If oil price increase by 1% gold price will decrease by 0.05 percent under the influence of oil price. The graphical presentation of the original values of oil price and gold rate are as follows:
The result of correlation between the exchange rate and the gold price is as follows;
Particulars
Exchange rate
Gold Rate
Exchange Rate
1
0.085
Gold Rate
0.085
1
The tabulated results show that there is slight positive correlation between the gold rate and the oil price which means that 1% increase in the exchange rate gives 0.085 % increase in the gold rate. The graphical presentation of the original data of gold price and the exchange rate is follows:
CONCLUSION
In this literature, I have tried to find the link between the US dollar effective exchange rate and real oil prices. Overall this study focus on only the US dollar effective exchange rate and real oil prices but later one other vital factor also included in the model which helps to find the corresponding relations between the variables. This study shows that there is a significant relation between the real oil prices and the effective exchange rate. In the short run, results may be inverse but in the long run results are in support of earlier studies, which concluded that there is positive relationship between the exchange rate and the effective dollar exchange rate.
The variation in the oil price is far more intense than the variation in the oil price. This phenomenon is apparent through the tested outcomes and the also in the graphical presentation. The adjustment speed of effective exchange rate is less than the oil price. Results also reveal that increase in the oil price will increase the net foreign assets of the United States of America. The countries whose currency is pegged to the US dollar will suffer less with the increase in the oil price and those countries who falls in the floating exchange rate is affected more.
The results also reveals the important fact, which is that the United States of America is enjoying the benefits of low price and cheapest oil based energy over the period of more than half century as oil price is denominated and traded worldwide in the US dollar. The increase in the oil price will increase the demand for more US dollars to buy the same quantum of oil and this increased demand will affect the exchange rate of the country with respect to the US dollar and this increase the import bill of the respective consumer countries and the producer countries will enjoy the benefits of more wealth.
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