This report analyzes the relationship between the dollar and the price of oil and how the two might interact. This report provides an assessment of the impact a range of prices of imported oil could have on the U.S. trade deficit.

This report provides an estimate of the initial impact of the changing oil prices on the nation's merchandise trade balance.

The paper examines welfare effects and the trade balance response to changes in the world oil prices and interest rates for a small oil-importing economy. The trade balance is mainly seen as the difference between saving and investment, and these are derived from intertemporal optimization. It is shown that the welfare effects consist of static terms of trade effects, intertemporal terms of trade effects, and employment effects. The trade balance deteriorates for temporary oil price increases, whereas its response is ambiguous for permanent oil price increases. For a fall in the world interest rate, the trade balance deteriorates, if the economy is a net borrower.

Despite common perceptions that there is a direct cause and effect relationship between changes in the international exchange value of the dollar and the price of oil, an analysis of recent data indicates that changes in the price of oil are driven by changes in the demand for oil that is different from the supply of oil, rather than changes in the value of the dollar. [...] While the data do not support a strong cause and effect relationship between the value of the dollar and the price of oil, there likely are various channels through which changes in the price of oil and in the value of the dollar may be indirectly correlated. [...] The data also indicate that an increase in the demand for crude oil that exceeded the increase in the supply of oil and a laggardly pace in oil production capacity likely are among the main factors behind the sharp run up in the price of oil that occurred over the first seven months of 2008. [...] In addition, changes in the international exchange value of the dollar likely reflect a number of factors, including changes in the demand for and supply of capital within the U. S. economy, the relative rate of return on interest-sensitive assets, and expectations about the performance of the U. S. economy. [...] The interaction between the price of oil and the value of the dollar is complicated further by the way changes in the price of oil can affect the economic performance of other nations and, therefore, have an impact on their respective currencies.9 According to Global Insight,10 a number of factors worked to put upward pressure on oil prices in 2007 and during the first half of 2008.

Petroleum prices have risen sharply since early 2004. At the same time the average amount of imports of energy-related petroleum products has fallen slightly. The combination of sharply rising prices and a slightly lower level of imports of energy-related petroleum products translates into an escalating cost for those imports. This rising cost added an estimated $70 billion to the nation's trade deficit in 2005 and could add $80-$100 billion in 2006, depending on how sustainable is the rate of recent price increases. This report provides an estimate of the initial impact of the rising oil prices on the nation's merchandise trade deficit.