Domestic and External Sources of Inflation in Saudi Arabia: An Empirical Study

Abstract

The main objective of this study is to determine the sources of inflation in Saudi Arabia. For achieving this objective a single-equation model of inflation in Saudi Arabia is specified and estimated. This model is based on the monetarist single-equation model of inflation. However, the model departs from the monetarist single-equation model of inflation by including the external factors that are expected to have impact on inflation in Saudi Arabia namely; the U.S. Dollar short-term market interest rate, the changes of the Saudi Riyal exchange rate against the U.S. Dollar and imported inflation. Our singleequation model includes three more explanatory variables beside the external variables. These variables are, nominal money supply, real income (real GDP) and the lagged dependent variable (pt-1). The empirical results that emerge from estimating our single-equation model of Saudi inflation reveal that all the explanatory variables, except the U.S. Dollar short-market interest rate, bear the correct sign and are statistically significant at the 5 percent level of significance. The overall fit of the regression (the estimated equation No. 4.3) is very good with five explanatory variables jointly explaining large proportion of the total variations in inflation rate (R 2 = 0.92). This means that our model fits the actual data remarkably well. The empirical results also indicate that among the various explanatory variables, three are found to exert especially strong effects on the Saudi inflation, namely, the growth rate of money supply, the growth rate of real income and the changes of the Saudi Riyal exchange rate against the U.S. Dollar. Moreover, the empirical results of this study support our expectation that the growth in money supply is an important source of inflation in Saudi Arabia. The depreciation of the Saudi Riyal against the U.S. Dollar is another important source of Saudi inflation (its long-run elasticity = 0.68). Finally, the real economic growth is found to exert relatively strong mitigating effect on inflation in Saudi Arabia.

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“…First, publicly available data on the Saudi interest rate are not available for a long enough sample period (i.e., 30 years or more). For this reason, earlier studies on the exchange rate and currency demand did not consider it in their empirical analyses (see discussions in [121][122][123][124][125][126][127]). This is true for measures of interest rates on both money and alternative assets.…”