Do Exchange Rates Matter?*

Oil prices have experienced large fluctuations in recent years.  The spike in crude oil prices in mid-2008 to more than $140/bbl, followed by a steep correction in late 2008/early 2009 and subsequent sharp rebound over the last two years have jolted the world economy and pinched consumers at the fuel pump. US dollar weakness in recent years is frequently cited as one reason for high oil prices. It is very common to see the financial press suggesting that a weak dollar has pushed oil prices higher. However, this explanation is challenged by the empirical observations that (a) a change in oil price tends to lead to a change in the exchange rate as predicted by economic theory and (b) the oil price has risen regardless of what currency unit one uses to measure the price of oil.

Exchange Rates and Oil Prices*

US dollar weakness in recent years is frequently cited as one reason for high oil prices. It is very common to see the financial press suggesting that a weak dollar has pushed oil prices higher. Empirically, there is clearly an inverse correlation between oil prices and exchange rates – that is, other things being equal, oil prices rise if the dollar falls. An assessment of the dynamic conditional correlation (DCC) and of the one-year rolling average correlation between the daily change in the oil price and the daily change in the nominal effective exchange rate shows that this relationship has been relatively strong in recent years, although the negative correlation has been declining in recent months. What is less clear, though, is the direction of causality. Several econometric techniques suggest that causality may run from the oil price to the exchange rate, rather than the opposite.