How Petrodollars Affect the U.S. Dollar

How Petrodollars Affect the U.S. Dollar

By Zaw Thiha Tun Updated January 24, 2022  Reviewed By Chip Stapleton  Fact Checked By Katharine Beer

After the collapse of the Bretton Woods gold standard in the early 1970s, the United States struck a deal with Saudi Arabia to standardize oil prices in dollar terms.1 Through this deal, the petrodollar system was born, along with a shift away from pegged exchanged rates and gold-backed currencies to non-backed, floating rate regimes.

The petrodollar system elevated the U.S. dollar to the world's reserve currency and, through this status, the United States enjoys persistent trade deficits and is a global economic hegemony.2

 The petrodollar system also provides U.S. financial markets with a source of liquidity and foreign capital inflows through petrodollar "recycling." However, a full explanation of the effects of petrodollars on the U.S. dollar requires a brief synopsis of the history of the petrodollar.

History of the Petrodollar

Faced with mounting inflation, debt from the Vietnam War, extravagant domestic spending habits, and a persistent balance of payments deficit, the Nixon administration decided in Aug. 1971 to suddenly (and shockingly) end the convertibility of U.S. dollars into gold. In the wake of this “Nixon Shock,” the world saw the end of the gold era and a free fall of the U.S. dollar amidst soaring inflation.3

KEY TAKEAWAYS

*Petrodollars are dollars paid to oil-producing countries for oil.

*The emergence of the petrodollar dates back to the early 1970s when the U.S. reached an agreement with Saudi Arabia to standardize the sale of oil based on the U.S. dollar.

*Petrodollar recycling creates demand for U.S. assets when dollars received for oil sales are used to buy investments in the United States.

*Recycling of petrodollars is beneficial to the greenback because it promotes non-inflationary growth.

*A move away from petrodollars could potentially increase borrowing costs for governments, companies, and consumers if sources of money become scarce.

Through bilateral agreements with Saudi Arabia beginning in 1974, the U.S. managed to influence members of the Organization of the Petroleum Exporting Countries (OPEC) to standardize the sale of oil in dollars. In return for invoicing oil in dollar denominations, Saudi Arabia and other Arab states secured U.S. influence in the Israeli-Palestinian conflict along with U.S. military assistance during an increasingly worrisome political climate, which saw the Soviet invasion of Afghanistan, the fall of the Iranian Shah, and the Iran-Iraq War. Out of this mutually beneficial agreement, the petrodollar system was born.

Benefits of the Petrodollar System

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