Oil Prices, US Inflation, US Money Supply and the US Dollar

A central proposition in many macroeconomic models is price stickiness, while it is agreed that commodity prices are determined in auction markets, and are necessarily fully flexible. The overall price level is a weighted average of commodity prices and consumer prices. An exogenous increase in the money supply, keeping everything else constant, increases the overall price level proportionately. Because of stickiness of consumer prices, commodity prices overshoot the increase in the money supply. The purpose of this paper is to re‐examine the relations between the price of one specific commodity which is oil with US inflation, US money supply and the US dollar. One empirical fact is that during the sample period, global and US demand shocks have raised oil prices immediately while their effect on consumer prices was delayed. This overshooting of oil prices is expected to occur in the short run and to wane in the long run as consumer prices fully adjust. The overshooting of oil prices is the mirror image of the overshooting of the US dollar. This is true for two main reasons. One, both oil and the US dollar react in the same manner to money supply changes. Two, oil prices are quoted in US dollars and a depreciation of the US dollar is instantly compensated by a rise in the US price of oil. Additionally, the paper analyses and discusses the evidence on an apparent long run overshooting of oil prices and explains why it is just a statistical artefact that stems from the salient features of oil.