Yeah, I’m beating this horse to death. Hey, it’s fascinating to me, alright? Besides, I’m finally starting to catch at least a glimpse of how this whole economics thing works, and given that economics underpins how our entire world works, it seems worth exploring.
Anyway, occasionally I’ve heard comments regarding oil and how it’s traded in US dollars. Further, I’ve heard the idea parroted that, if the world were to switch to a different currency for trading oil (like, say, the Euro), the US dollar would experience a significant decline in it’s exchange rate. But I never really understood why that would be. Until yesterday, anyway.
As I mentioned in my previous post, the foreign exchange market is where the exchange rate for currency is determined, and that value is based on supply and demand. If the demand for a currency is high (say, because people want to invest in that country’s economy, or purchase it’s exported goods), then the exchange rate will be high.
Now consider that oil is currently traded exclusively in US dollars. That means any nation wishing to purchase oil on the open market must first convert their currency to US dollars in order to participate in the market. Voila, all of a sudden demand for the US dollar is maintained at an artificially high level, thus propping up the US exchange rate. Now imagine everyone switched over to the Euro. Suddenly a major source of demand for US currency evaporates, and the result would be a massive drop in the US exchange rate, which would cause, among other things, sudden domestic inflation as the price for imported goods shot through the ceiling. Hello recession!
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