Bryan Caplan  

The Dollar and the Gas Pump

How Family Environment Works... Blaming the Fed...

Oil is sold on world markets, and the dollar is now very weak. What would the dollar price of gas be today, if the dollar were as strong as it was back in 2002? Here's a back-of-the-envelope calculation (gas price data are here; exchange rate data are here):

Today a dollar buys you .6451 Euros, and it takes $4.134 to buy a gallon of gas. Suppose the dollar were still at parity with the Euro, as it was on 11/23/2002 (actually 1.0030, but who's counting?). In that case, a dollar would buy you (1/.6451)=1.55 times as much. So a gallon of gas would be only $2.667.

The actual price of gas back in the third week of November, 2002 was $1.451. So to a first approximation, if the dollar had been stable, gas prices would have risen by about 80%, instead of 280%.

Admittedly, the U.S. is a big player in world oil markets; if the dollar had been stronger, it would have partly raised the world price of oil, and thereby the domestic price of gas. So maybe a stable dollar would have left gas prices 100% higher rather than 80%. If you adjust for the fact that some costs of gasoline (refining, taxes) are purely domestic, maybe gas would have been 150% more expensive even given a stable dollar. (Can anyone point to more sophisticated calculations?)

Whatever way you slice it, though, the effect of the exchange rate on the price of gas turns out to be enormous. Our present search for scapegoats is deeply misguided, but a few people really are personally responsible for the high price of gas. Contrary to popular opinion, though, they aren't CEOs in the oil industry; they're the leaders of the Federal Reserve System. It's easy to point fingers; but sometimes finger-pointing is right on target.

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COMMENTS (17 to date)

Very interesting and well researched article! The first solution, for oil price stability, is oil should not be priced in only dollars. It needs to be priced in a basket of currencies. This would take much of the “currency” speculation and hedging volatility out of the prices.

mgroves writes:

Can we in turn say that the Federal Reserve's effect on inflation has largely been in response to credit issues surrounding ARMs and the like?

Can we in turn say that the price of gas has been driven up, at least in part, by people buying more house than they can afford, and companies giving loans to people they shouldn't have (i.e. Freddie Mac and Fannie Mae)?

So can we then say that if it weren't for government intervention into matters that are more efficiently governed by markets, gas would be cheaper and the foreclosure rate would be lower?

megapolisomancy writes:

What about the price of oil in gold?

Perhaps we need to move away from a government controlled currency:

Gary Rogers writes:

This puts the blame a step closer to where it belongs, but when you look at the current situation, what is the Fed supposed to do? They have a dual mandate to keep inflation under control while maintaining full employment. At the same time their efforts are undercut by a congress that continues to spend more than it takes in with increasing unfunded promises stretching as far into the future as we can see. The dollar is weak because of an irresponsible congress. I think the Fed has done a pretty good job with what they have to work with. How many economists were brave enough to warn against the last round of rate cuts?

andres writes:

Gary Rogers is correct. The dollar has plunged because of the budget deficit, not because of Fed policy. It's quite astounding that even economists like Caplan don't see this.

aaron writes:

I don't think it captures all the blame, prices could be lower if politician cared the slightest about properly managing traffic and getting good information to people (like that accelerating faster is more efficient than accelerating slowly).

Probably the cheapest and most effective thing we could do to lower gas prices (besides magically deciding the dollar will be stronger) is properly timing traffic lights, setting proper speeds, and getting good information to the public.

aaron writes:

(Think of what whould happen to the price of gas if our gas consumption declined 4.3% along with our driving. In reality, our driving declined this year, but we used about just as much gas.)

TGGP writes:

Which presidential candidate chose the Fed as a scapegoat? That's right, Ron Paul, but as Giuliani told us he's crazy.

Charlie writes:

Your implicitly assuming that 100% of the change in exchange rate is due to the federal reserve board, but you provide no support for such a claim. Many things can potentially change the exchange rate. An obvious target might be a decreased demand to hold US assets.

Without attempting to show the amount of the change in the exchange rate was due to US monetary policy, how can we blame the Fed?

Joseph Teicher writes:

your analysis seems flawed. Using the euro as a proxy for the decline in the value of the dollar is strange because the euro has appreciated relative to most major currencies, not just the dollar.

Also, using retail gas prices doesn't make sense because there are all sorts of components of that price that haven't changed at the same rate as crude. For instance, taxes and retail markup probably made up a larger percentage of the retail price of gas in '02 than they do now, but for your analysis to hold they would have had to moved proportionally to the wholesale price of gas.

Using crude oil would have made a lot more sense since that is what has been driving the price of gas, but the numbers don't work nearly so nicely for you. At the end of '02 crude was around $33/barrel and the euro was around $1.05. Today crude closed at $136.27 (front month nymex future) and the euro was at about $1.5535. In euros crude has gone from around 31 to 88, so in dollars the change has been a little over 300% and in euros it has been only 170%, which is a big difference but not as big as the one in your post.

The fallacy with that analysis though is to think that if the euro had stayed at parity with the dollar somehow we would have $88 crude even though the eurozone imports less crude than we do, and china and japan are the second and third largest importers. In all likelihood if the euro had stayed at parity oil would be a little cheaper in dollar terms and a lot more expensive in euro terms.

spencer writes:

The taxpayers of Virginia actually pay you to teach their children economics.

Essentially your analysis of the impact of the dollar takes the first of several steps it should.

You did step one that shows the Euro price has increased less then the dollar price.

But the next step should have applied the European price elasticity of demand to see how much of an impact the smaller price increase in euro prices impacted European demand.

Third, you would have to adjust this to account for the point that domestic taxes account for a much larger share of the domestic price of oil in the euro countries. Consequently, a $1 increase in the price of crude has a much smaller impact on european gasoline prices then US gasoline prices.
But you need to adjust for this.

third you should have then applied this adjustment to the euro countries share of world consumption -- under 20% -- to see how much this would impact total world demand.

Next, you would have to do this same analysis for other regions, like eastern europe and/or china and India -- they accounted for 85% of the increase in world oil demand in 2007 -- Latin America, Africa, etc..

I can not believe that you have a PhD from a reputable university and have seriously tried to pass off this simple analysis as serious economics.

What would your professors have said if you had tried to pass off this analysis as your answer in your exams for a PhD. I can not believe that their is a single PhD granting economics department that would have passed your simplistic analysis.

David writes:

Charlie does have a point, where a dollar was worth .6420 pounds on 11/30/2002 and .5102 today. This would align with a story of about 4.2% inflation, which I think was the number I saw in an article in the Post this morning (because that definitely validates my data, but it does sound more realistic than the 8% annual inflation that the European comparison implies).

It's also true that this was before ethanol was mandated to replace MTBE, and that is an additional expense.

James writes:


You said it! At the very least the post should have included some caveat mentioning that there are probably other relevant factors and that a more sophisticated analysis is probably necessary.

Oh, wait...

Kudzu Fire writes:

the bottom line is: Drill here. Drill Now. Pay Less.

Duxem writes:

Saving consumers’ cash on the spot at the gas pump. These are the kinds of innovative ideas that we are implementing at Revolution Money.

John V writes:

Well said, James. Thank you.

Duxem writes:

Hi,As a consumer you have the option of obtaining a gasoline credit card from any of the gas stations in your area. These credit cards are meant to help you save a little on each fuel purchase you make.

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