World Review of Business Research
Vol. 1. No. 4. September 2011. Pp.109-114
Determinants of Inflation in Saudi Arabia
Hamad A. Altowaijri*
This paper investigates the factors that affect the rate of inflation in Saudi Arabia.
The inflation in Saudi Arabia was very low during the eighties and nineties;
however, it has started accelerating since 2003. This paper utilizes a model which
incorporates both domestic and foreign factors affecting the rate of inflation. The
findings suggest that external factors are the main source of inflation, which is
consistent with the fact that the Saudi economy is very open and most goods are
imported from the outside world. The increase in world prices and the fall in the
Dollar are found to be important determinants of the inflation rate in both the short
and long run. Also the increase in domestic demand, which has resulted from the
increase in oil prices, has raised the inflation rate.
1.
Introduction
Inflation in Saudi Arabia was kept very low at around 1%, in the eighties and nineties
as a result of a weak oil market which had caused the oil revenues to decline.
However the rate of inflation has accelerated since the year 2003. The rate of
inflation has exceeded 11% in 2008, which has negatively affected most of the
population. Although the rate of inflation had fallen as a result of the World financial
crisis, it has started increasing since 2010. This rise in inflation was caused by many
domestic and external factors. As a result of the high oil revenues which have
enhanced government spending, local consumption has grown annually by more
than 13% while investment spending has grown by 21% annually during the last
three years. Also the increase in money supply by around 20% annually may have
accelerated inflation. In addition, World prices of food, energy, and most other input
factors added to the rise in inflation. Another contributory factor was the sharp
increase in rents and prices of housing, which resulted from the increase in demand
due to the growth in population, the increase in income and the shortage of housing
supply. Finally, the fall in the U.S. Dollar against most of the major currencies has
pressured the prices of imports.
Using quarterly data from 1996 (1) to 2010 (4), this paper aims to investigate what
determines the rate of inflation in Saudi Arabia, in order to know the external an
internal sources of inflation and what policies are effective in stabilizing prices.
Section 2 of this paper presents a theoretical framework of inflation in Saudi Arabia.
Section 3 examines the short run and long run relationships between inflation and its
determinants. A final section concludes the study.
Dr.Hamad AL-Towaijri, Department of Economics, King Saud University, Saudi Arabia, Email
Hamad_towaijri@yahoo.com
Altowaijri
2. Literature Review
Empirical studies on the determinants of inflation have focused on some external and
domestic factors causing inflation. These factors are mainly monetary, demand, cost
push and foreign in nature. The findings of these studies are different. Hasan and
Alogeel (2008) found that demand and money supply affect inflation in the short run,
while foreign inflation affects inflation in Saudi Arabia and Kuwait in the long run.
Darrat (1985) found that inflation in Saudi Arabia, Libya and Nigeria correlates with
higher money supply and lower real income growth. Keran and Almalik (1979) found
that inflation in Saudi Arabia is more affected by World prices than by monetary
sources.
Alshathree (2003) investigated the sources of inflation in the Gulf Cooperation
Council (GCC) countries and found that inflation was caused by both internal factors
including money supply growth, and GDP growth; and external factors including
import prices, world prices, and interest rates. Also, Alshathree concluded that
inflation does not cause a threat to the GCC economies in the short run, However, it
could harm these economies in the long run. Mehran (2007) found that world prices
are the main source of inflation in the GCC countries as a result of their dependency
on imports.
Kandil and Morsy (2009) found that oil prices are the main source of inflation in the
GCC countries. They stated that oil price affects World prices which in turn increases
the price of imports. Also the rise in the oil price causes an increase in government's
revenues and spending which tends to push domestic demand resulting in inflation.
Dhakal and Kandil (1993) studied inflation in six South East Asian countries, and
found that external sources were the main determinant affecting inflation. The same
results were found in Poland, Albania and Romania. However, Bertocco (2002) found
that inflation in Italy is affected by wages and mark up pricing. Finally, Dwyer and
Gurney (2010) calculated that the output gap plays a big rule in explaining the
inflation in the U.K.
3. The Methodology and Model
A formal theoretical model of inflation determination is presented in this section. The
model includes several external and domestic factors that affect inflation in Saudi
Arabia. Saudi economy is an open economy; it highly depends on imports which
results in an increase in the cost of imports from inflation-prone countries and a
transfer of inflation from these trading partners. The domestic price is also affected by
the price of non-tradable items which depends on monetary factors. The general
price level is a weighted average of the price of tradable goods (Pt) and the price of
non-tradable goods (PN)
𝑙𝑜𝑔𝑃𝑡 = 𝑙𝑜𝑔𝑃𝑡 + 1 − λ (𝑙𝑜𝑔𝑃𝑁 )
Where
0<λ<1
(1)
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The price of tradable goods depends on external factors, the foreign price (P f) and
the real exchange rate (reX)
𝑓
𝑙𝑜𝑔𝑃𝑇 = +𝑙𝑜𝑔𝑃𝑡 + 𝑙𝑜𝑔𝑟𝑒𝑋𝑡
(2)
The price of non tradable goods is affected by domestic demand which is in turn
determined by the money market equilibrium conditions.
𝑙𝑜𝑔𝑃𝑡𝑛 = β 𝑙𝑜𝑔𝑀𝑡𝑠 − 𝑙𝑜𝑔𝑀𝑡𝑑
(3)
Where 𝑀𝑡𝑠 = Real money supply
𝑀𝑡𝑑 = Real money demand
Real money demand is a function of real income (y), expected inflation (e) and the
interest rate (r).
𝑀𝑡𝑑 = 𝑓(𝑦, 𝜋 𝑒 , 𝑟)
(4)
Assuming adaptive expectations, the expected rate of inflation equals the rate of
inflation in the previous period.
𝜋𝑡𝑒 = ∆ 𝑙𝑜𝑔𝑃𝑡−1
5
substitution, the following equation of inflation is constructed:
𝑙𝑜𝑔𝑃𝑡 = α0 + α1 𝑙𝑜𝑔𝑌𝑡 + α2 𝑙𝑜𝑔𝑃𝑡−1 + α3 𝑙𝑜𝑔𝑀𝑡 + α4 𝑙𝑜𝑔𝑅𝑡 + α5 𝑙𝑜𝑔𝑅𝐸𝑋𝑡
𝑓
+ α6 𝑙𝑜𝑔𝑃𝑡 + 𝑈𝑡
Thus all exogenous variables; the real GDP; the money supply; the real exchange
rate and the foreign prices are expected to increase the price level, while the interest
rate is expected to reduce the price level.
4. The Findings
The Saudi economy has experienced a very low rate of inflation during the period
1981-2003, the period which followed the oil boom in the seventies. During that
period, the inflation in Saudi Arabia fluctuated between very low inflation and
deflation, with an average rate of below one percent. However, the rate has grown
rapidly since 2003, and it reached its maximum in 2008. Yet as a result of the world
financial crisis, the rate of inflation had decreased during the last quarter of 2008 and
during 2009. Nevertheless it has started rising again since 2010.
The data used in this study are quarterly observations for the period 1996-2010,
which includes 60 observations. M, the money supply, P, the price level, r, the
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interest rate, and Y, the nonoil GDP are obtained from Saudi Arabian Monetary
Agency, SAMA sources. The annual nonoil GDP annual data is transformed by a
linear interpolation technique to quarterly data. The foreign prices and real exchange
rate are extracted from the IMF publications.
Table 1 shows the unit root tests for the variables in logarithmic form; at the levels
and the first differences.
Table (1): Unit Root Tests
Variables
Unit Root in
Unit root in 1st
levels
difference
LCPI
0.62
-7.5
LY
2.61
-4.33
LM
0.87
-6.90
LR
-2.78
-5.69
LFINF
-1.35
-4.62
LREX
-1.32
-3.15
The Augmented Dickey-Fuller (ADF) statistics show that all variables are stationary in
first differences, I (1).
Following Johansen and Juselius (1990), a cointegration test is conducted.
r=0
r≤1
r≤2
Table (2): Cointegration Test
Trace Stat.
5%
Critical Max-Eigen
Values
Stat
100.73*
69.82
57.61*
43.12
47.85
18.86
24.26
29.79
13.85
5%
Critical
Values
33.87
27.58
21.13
The results indicate the existence of one cointegrated equation at the 5% level.
The Error Correction Estimation of the inflation equation was conducted and the long
run equation can be written as:
𝐿𝐶𝑃𝑖 = 4.0 𝐿𝐺𝐷𝑃 + .42 𝐿𝑀 − .21 𝐿𝑅 + .47 𝐿𝐹𝐼𝑁𝐹 + 6.26 LREX
(3.07)
(.5)
(-.85)
(2.6)
(6.33)
−.02 𝑡𝑟𝑒𝑛𝑑
(-2.01)
Where figures in brackets beneath the coefficients are t-values.
The short run equation can be written as:
𝐷𝐿𝑃 = −.22 + 0.80𝐷𝐿𝑃(−1) − 0.2 𝐷𝐿𝑌 −2 + 0.01𝐷𝐿𝑀(−1)
(-1.93) (6.80)
(1.88)
(1.41)
𝑓
−.05 LR + 0.2 𝐷𝐿𝑃 (−2) + 0.11𝐷𝐿𝑒𝑋 − 0.30𝐸𝐶
(-1.2)
(2.17)
(3.31)
(-1.9)
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In the long run all variables have the expected sign and they are all significant except
the money supply and the rate of interest variables. Also in the short run the money
supply does not cause inflation. The results assure that the inflation in Saudi Arabia
is mainly derived by foreign factors. However, monetary policy does not play any role
in determining inflation in Saudi Arabia which weakens its effect on the welfare and
the economy as a whole regarding curbing inflation and maintaining price stability.
5. Summary and Conclusions
This paper provides a study of the determinants of inflation in Saudi Arabia during the
period 1996-2010. This period of time involved a large change in the rate of inflation,
as a result of domestic and external factors. The results suggest that external factors
are the main sources of inflation, which is consistent with the fact that the Saudi
Economy is highly open where the majority of goods are imported from abroad. The
increase in World prices and the fall in the Dollar against major currencies, have
triggered high inflation rates in both the short and the long run. Also shifts in domestic
demand — as a result of the upsurge of oil prices — has raised the inflation rate.
However, it appears that money supply had no effect on the rate of inflation which
could be explained by the fact that the Saudi Riyal is pegged to the Dollar which
causes the Saudi interest rate to follow the fed rate blindly. This has weakened the
domestic monetary policy on one hand, and low interest rate on the US dollar has
dampened the interest rate effect on inflation, on the other hand.
Finally, in order to curb the level of inflation, the Saudi economy needs to be
reconstructed in a way to diversify the economy and increase the domestic output
leading to reduction of its dependency on imports. Also, there is a need to reconsider
the exchange rate policy either to stop pegging the Saudi Riyal to the Dollar or to
adopt some flexibility on the relationship between the Riyal and US Dollar; a crawling
peg regime may be preferred in this context.
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