Petroleum industry and trade ; Money supply

Douglas R. Mudd

Geoffrey E. Wood

English

Research Papers in Economics

•. the cost of foreign oil to the U.S. economy —
$45 billion this year, contributing to an estimated
$30 billion trade deficit — is weakening the dollar’s
value overseas and causing fresh concern about fu-
tore U.S. economic stability.1
The above is one of many similar statements made
during the past year reflecting the widely held belief
that oil imports are the cause of the fall in the value
of the dollar. Since imported oil in 1977 was the
largest single component of total U.S. merchandise
imports, the assertion is superficially plausible. How-
ever, a slightly more wide-ranging look at the facts
provides substantial evidence that this contention is
incorrect.
How much oil do other countries import? Certainly
most Western countries import less oil than does the
United States, but that is not surprising, since the
United States is the largest economy in the West. In
comparing oil imports across countries, these imports
should be related to the size of each economy. Such a
comparison reveals what fraction of the income from
domestic production is being used to keep the country
supplied with imported oil, thereby relating oil expen-
ditures to what is actually available to be spcnt.2 The
~Harry B. Ellis, “Congress Imperils Oil-Cut Plan,” Christian
Science Monitor, October 11, 1977.
2
This is the same kind of comparison one makes, for example,
when determining whcther a person’s debts are too large. One
looks not just at the debts, but at the debts relative to assets
and income; only in that way can one calculate what the per-
son can afford.
Page 2
results of relating expenditures on oil to the level of
national income for the United States, Germany, and
Japan are sho\vn in Table I. It is immediately clear
that the United States imported less oil as a percent-
age of its Gross National Product than either Ger-
many or Japan in each year from 1970 through 1977.
And yet the currencies of both Germany and Japan
have appreciated, not only against the U.S. dollar, but
also against almost every other currency in the world!
(In 1977, the Deutsche mark rose by 11.3 percent
against the dollar and by 7.0 percent against an aver-
age of currencies, while the yen rose by 20.8 percent
against the dollar, and by 19.2 percent against an
average of currencies.)
The simple relationship that is often suggested be-
tween large oil imports and a weak currency plainly
is hard to reconcile with these facts. To see why this
is so, it is necessary to examine the composition of the
balance of payments in some detail.
Thc balance-of-payments accounts of each country
summarize its transactions with the rest of the world.
These transactions can be subdivided in many ways.
For present purposes it is most useful to separate
them into three groups — the current account, which
comprises the balance of trade and unilateral trans-
fers, that is, gifts to foreigners; the capital account,
which comprises capital movements for inves~nent
Oil Imports and the Fall of the Dollar
DOUGLAS B. MUDD and GEOFFREY E. WOODFEDERAL RESERVE BANK OF ST. LOUIS AUGUST 1978
lobe I
OIL IMPORTS: AN INTERNATIONAL COMPARISON
Total Oil Imports as a Percent of GNP
1970 1971 1972 1973 1974 1975 1976 1977
U.S 0.3% 0.3% 0.4% 0.6% 1.7% 1 6% LS% 2 7%
Germany 1.3 1.5 L3 1.6 3.3 2.8 3.1 29
Japan 1.1 1.3 1.3 1.5 4.2 4.0 3.8 3.4
r..zrrr I, tci,. ahnva
7
~7, ~.,‘aru
purposes by both the private sector and the govern-
ment; and the intervention account, which comprises
official movements of funds effected with the intention
of influencing exchange rates.
The balance of trade includes all transactions in
goods and services between a country and the rest
of the world. All receipts from the sale of goods and
services abroad are summed, all expenditures by a
country’s residents (including industry and govern-
ment) on foreign goods and services are then sub-
tracted, and the resulting total is the balance of trade.
It can be positive (if receipts exceed expenditures),
negative (if expenditures exceed receipts), or zero.
Expenditures on imported oil appear in this part of
the balance-of-payments accounts. In 1977, the United
States was in deficit on its trade account with the rest
of the world — that is, expenditures exceeded receipts
— by some $10.5 bfflion.3
The United States must pay for this excess of ex-
penditures over receipts in exactly the same way that
an individual pays for expenditures which exceed
receipts. The country can either sell its assets or bor-
row. These transactions are summarized in the cap-
ital account, which is subdivided between private and
official capital movements. Capital movements for
investment purposes are from one economy to either
the private or the government sector of another econ-
omy. When someone buys securities from, or lends
money to, a U.S. resident (including businesses and
the U.S. Government) this transaction is called a
capital inflow. The converse transaction is called a
capital outflow, The former is an inflow because it
provides funds which can be spent, and the latter is
an outflow because it is a way of disposing of funds.
Since different countries use different currencies,
a country with a deficit on its trade account (like the
United States last Year) has spent more foreign cur-
~The figure reflects the June 22, 1978, change in the presen-
tation of the balance-of-payments accounts. Unilateral trans-
fers totalled $4.7 billion in 1977, resulting in a current ac-
count deficit of $15.2 billion.
rency on foreign goods than it has received from
foreigners. In other words, foreigners want less U.S.
currency than the amount U.S. residents want to
trade for foreign currency, The quantity of U.S. cur-
rency supplied (the amount U.S. residents want to
spend) exceeds the quantity demanded (the amount
foreigners want to buy) at the existing price of the
currency on the foreign exchange market.4 When the
quantity supplied exceeds the quantity demanded,
price falls (the currency depreciates). This has the
effect of decreasing the quantity supplied and in-
creasing the quantity which is demanded; only when
the two are equal — when the amount people want
to supply equals the amount that people demand at
the current price— is there no further change in
price.
But while a trade deficit clearly does indicate that
U.S. residents want to spend more dollars on foreign
goods than foreigners wish to acquire to spend on
U.S. goods, that does not mean that the total amount
of U.S. dollars supplied on exchange markets exceeds
the quantity demanded. This is because, as noted
above, U.S. dollars can be both demanded and sup-
plied for reasons other than trading in goods and
services.
If foreigners wish to invest in the United States,
they must acquire dollars. Similarly, if U.S. residents
wish to invest outside the United States, they must
acquire foreign currency. These capital movements
provide both a source of supply and a source of
demand for U.S. dollars on the foreign exchange
market. It is quite possible, therefore, for a deficit in
the trade account, which would lead by itself to an
excess supply of dollars, to he fully offset by such
capital flows.5 Thus, there is no necessary connection
between a trade deficit and a depreciating currency.
1The foreign exchange market is where currencies are traded.
It is not a single location, but a network of traders all around
the world.
5
1t can also he more than offset, so that the United States
would either have an appreciating currency or an increase in
its international reserves.
Page 3FEDERAL RESERVE BANK OF ST. LOUIS AUGUST 1978
What if, at the prevailing exchange rate, there is
still an excess supply of a currency when both the
trade account (plus unilateral transfers) and the
capital account are considered? It is here that the
official intervention account can become important.
An excess supply of a currency can be removed by
governments using other currencies to purchase the
excess quantity, thus preventing its pnce from falling.
This is what is called official intervention in foreign
exchange markets.°
The important point to remember is that a deficit
in the trade account does not necessarily cause a cur-
rency to depreciate. The excess supply of a currency
which a trade deficit by itself implies can be offset by
capital movements or official intervention to support
the exchange rate, or both.
The United States ran a $35.2 billion balance-of-
payments deficit in 1977,~Even after substantial offi-
cial exchange market intervention by several coun-
tries to buy dollars, the foreign exchange value of the
dollar fell. This implies that the quantity of U.S.
dollars supplied on foreign exchange markets ex-
ceeded the quantity demanded; consequently, the
price fell, reducing quantity supplied and increasing
quantity demanded.
To repeat, recognizing that foreign currency values
(or, in the presence of official intervention, reserve
flows) are determined by the balance of supply and
demand, just as is any other price, involves in turn
recognizing that the U.S. dollar’s value must have
fallen because the dollar was in excess supply at the
original exchange rate.
i’~ow,every component of U.S. imports contributes
to the supply of dollars on the foreign exchange mar-
ket; hence, if one is to look at imports, there is no
particular reason to look only at oil. But, more to the
point, the above analysis of the balance of payments
shows that any balance-of-payments position other
than exact balance (on trade and capital accounts
combined) implies an excess supply of one currency
relative to those of the rest of the world.8
°Itcan he seen from the above description that government
capital movements for some reason other than to support
the exchange rate have been classified with private sector
transactions.
~“Balance of payments” is defined here as all international
transactions excluding changes in official reserves.
5
This point was made explicitly by David Home in 1752 [“Of
the Balance of Trade,” David Hume: Writings on Economics,
Page 4
If the U.S. money stock, for example. exceeds the
amount people are willing to hold given the structure
of interest rates and income levels — that is, there is
an excess supply of money — then people will increase
their spending as they attempt to reduce their hold-
ings of money to desired levels. Spending on foreign
goods, services, and securities, as well as domestic
spending, will rise, As a result, the amount of dollars
supplied on the foreign exchange market will in-
crease. If the excess supply of money in the United
States is greater than excess supplies of money in
other countries, then the quantity of dollars supplied
on the foreign exchange market will increase relative
to quantities of other currencies supplied. Thus, the
price of the dollar in terms of other currencies (its
exchange rate) will come under downward pressure.
Eventually, if U.S. monetary growth does not con-
tinue to accelerate relative to any excess money
growth abroad, movement toward equilibrium inboth
the domestic money market and the foreign exchange
market will be accomplished as the U.S. price level
rises and the foreign exchange value of the dollar
declines. However, should the U.S. excess money
supply continue increasing relative to that abroad,
the foreign exchange value of the dollar will continue
to fall; or, if there is intervention in the exchange mar-
ket by central banks, a continuing balance-of-pay-
ments deficit will result,°
So far it has been shown that a balance-of-payments
deficit (or depreciating currency) must imply excess
monetary growth (relative to any excess money
growth there may be abroad) in the country whose
exchange rate is depreciating. Can oil imports cause
such an excess?
The comparison between the United States and
other countries made at the beginning of this article
shows that oil imports do not have to cause excess
monetary expansion, and hence an excess supply of
dollars on the foreign exchange market. (The
ed. Eugene Rotwein (Madison: University of Wisconsin
Press, 1970), pp. 60-77]. In this century, it is associated par-
ticularly with the work of I-larry C. Johnson, for example,
“The Monetary Approach to Balance-of-Payments Theory,” in
The Monetary Approach to the Balance of Payments, ed.
Jacob A. Frenkel and Harry G. Jolmson (London: George
Allen and Unwin Ltd., 1976), pp. 147-67.
°If the excess money growth is not restrained, interest rates
will rise as inflation accelerates. If, on the other hand, the
excess money growth is held back, then the dollar will stop
falling and there will be no upward trend in interest rates.FEDERAL RESERVE BANK OF ST. LOUIS AUGUST 1978
Deutsche mark and yen have certainly not been
depreciating on the foreign exchange market.) But it
is useful also to look at the actual data on oil imports
into the United States, and how the revenue which
accrued to non-U.S. residents as a result was spent.
The value of oil imports has indeed accounted for
a substantial proportion of merchandise imports since
the price increases of 1974. In 1977, for example, the
value of oil imnports totalled $45 billion, amounting
to 30 percent of total U.S. merchandise imports. But
the U.S. balance-of-trade deficit with oil-exporting
countries was only $16.9 billion in 1977.10 That it
was substantially less than U.S. expenditures on oil
shows that the oil producers spent considerable
amounts on U.S. goods and services. Furthermore, oil-
exporting countries’ net purchases of U.S. corporate
stocks and bonds and U.S. Government securities were
about $7 billion during l977.’~ Oil-exporting coun-
tries’ holdings of U.S. commercial bank deposits also
increased by abont $400 million during the past year.
These capital inflows offset about 45 percent of the
1977 U.S. balance-of-trade deficit with oil exporting
countries,12
Reduction (or elimination) of oil imports certainly
would not produce an equal reduction in (or elimi-
nate) the current U.S. balance-of-trade deficit. To the
extent that dollars earned from oil exports to the
United States are used to purchase U.S. goods, serv-
ices, and securities, the balance-of-payments effects
of rising oil imports by the United States are offset.
To reduce the U.S. balance-of-trade deficit by reduc-
ing the amount of oil imports would require oil-
exporting countries to maintain both their current
purchases of U.S. goods and their current rate of in-
vestment in the United States, despite a fall in their
loThis figuire does not reflect the presentational change in the
balance-of-payments accounts of June 22, 1978. If it were
possible to make this presentational change, the above U.S.
bilateral trade deficit with the oil exporting countries would
be reduced sharply.
tmm
Direct foreign exchange market intervention by the members
of OPEC is negligible. Thus, purchases of U.S. Government
securities by OPEC governments presumably reflect invest-
ment decisions, rather than the results of exchange market
intervention.
12
A detailed account of U.S. transactions with OPEC can be
found in Christopher L. Bach, “OPEC Transactions in the
U.S. International Accounts,” Survey of Current Business
(April 1978), pp. 21-32. It should be noted that had prices
risen as they have done in the United States without a fall
in the foreign exchange value of the dollar, OPEC members
would probably have spent less in the United States than
they actually did, since U.S. goods and capital assets
would have been more expensive, relative to those in the
rest of the world, than they now are.
earnings. It is hard to imagine that countries would
continue to both spend and invest as they now do
when faced with a substantial drop in income. Re-
ducing U.S. oil imports would therefore almost cer-
tainly reduce both U.S. exports and capital inflows
into the United States.18
Furthermore, consider what would happen to other
components of U.S. expenditures if oil imports were
suddenly cut off and there were no cutback to excess
money growth in the United States. U.S. residents
would wish to spend the money that was previously
spent on oil. Some of it would be spent on other
imports. Some would be spent on goods that had
previously been exported. There would be increased
demand for goods which had been previously pro-
duced and consumed domestically. This would divert
to the production of these goods resources previously
used elsewhere, and would thereby further reduce
U.S. exports and increase U.S. imports. Some of the
money would be used to purchase capital assets
abroad. And, of course, some of the money would be
used to purchase capital assets in the United States,
which would raise their price and reduce the rate of
interest, thereby, in turn, reducing the inflow of capi-
tal from abroad.
A cutback on oil imports without a cutback on
excess money growth in the United States (relative
to any excess money growth there may he abroad)
could not have a marked effect on the U.S. balance of
payments or the foreign exchange value of the
dollar. And, of course, if U.S. money growth were
cut back sufficiently to eliminate the excess supply of
dollars on the foreign exchange market, then the slide
in the dollar’s foreign exchange value would end
without any misguided and welfare-reducing attacks
on individual components of U.S. foreign trade.14
mIt may perhaps be argued that the U.S. “oil deficit” has
produced expectations of a falling U.S. dollar, and hence a
flight from the dollar to other currencies, hut this cannot be
reconciled with the strength of the Deutsche mark and Jap-
anese yen — Cenuany and Japan have /arger “oil deficits,”
relative to the size of their economies, than does the United
States. The argument that the “oil deficit” has produced the
fall of the dollar through its effect on expectations is there-
fore not persuasive.
14
The oil price increases would have had a minor effect on the
value of the U.S. dollar to the extent that the price in-
creases reduced real income in the U.S. See Robert H.
Rasche and John A. Tatoun, “The Effects of the New
Energy Regime on Economic Capacity, Production, and
Prices,” this Review (May 1977), pp. 2-12. This fall in
real income would reduce the demand for money, and thus
produce an excess supply of dollars without any change in
the quantity supplied. But there are two reasons why oil
imports cannot, via that route, be blamed for the fall in the
Page 5FEDERAL RESERVE BANK OF St LOUIS AUGUST 1978
The increasing value of U.S. oil imports has not
“caused” the U.S. balance-of-payments deficit and the
declining foreign exchange value of the dollar. Oil-
exporting countries’ purchases of U.S. goods and serv-
value of the dollar. First, when that excess supply had been
disposed of, the dollar would stop falling, and there would
not be the sustained slide we have seen since early 1977.
Second, the Federal Reserve, should it have chosen to do so,
could have reduced the money stock so as to eliminate that
excess.
ices and their investment in the United States have
offset, to a large extent, the balance-of-payments ef-
fects of rising oil imports. Thus, policies directed to-
ward reducing oil imports \vill have little effect on
the current trend of the dollar’s declining foreign
exchange value. Further, the primary determinant of
the 1976-77 deficits was not “an insatiable appetite”
for foreign oil. Balance-of-payments deficits and weak
currencies are monetary phenomena, resulting from
excess money growth in the country with the deficit
relative to money growth abroad.
Page 6

Oil imports and the fall of the dollar

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Oil imports and the fall of the dollar

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