Inflation and exchange rate policies in Saudi Arabia: an inflation targeting perspective

This research evaluates the effectiveness of the current fixed exchange rate regime between the USA dollar and the Saudi Arabian Riyal in place since 1987, from the perspective of the Saudi Arabian economy. From the USA’s point of view, the regime is beneficial as it guarantees a stable value of oil imports from Saudi Arabia at all times. However, this is not necessarily the case for Saudi Arabia, in particular when the USA authorities engage in expansionary monetary policies in order to stimulate the USA economy and Saudi Arabia is subject to inflationary pressures. That is not to say that the current fixed exchange rate regime is ineffective for the Saudi Arabian economy at all times. When both the USA and the Saudi economies are experiencing sustainable growth, the regime works for both countries. In other words, business cycle synchronicity is a prerequisite for the regime to be conducive to maintaining low inflation in Saudi Arabia via anchoring inflationary expectations, in the same way business cycle synchronicity is assisting Eurozone’s viability. In the absence of such synchronicity, the regime produces rigid monetary policies for Saudi Arabia, as it effectively renders them ineffective, and the Saudi authorities have to resort to contractionary fiscal policies as the only alternative to reducing deficits. The thesis is therefore evaluating alternative exchange rate regimes that could potentially be adopted by Saudi Arabia, and tests their effectiveness. Despite therefore Saudi Arabia resuming its stable macroeconomic framework when its economy is recovering, which is, quite often attributed to its fixed exchange rate regime, alternative regimes could provide Pareto improvements in particular when the Saudi economy is in recession. By estimating ARDL and VECM models, the thesis provides strong evidence in favour of an exchange rate regime based on inflation targeting. The application of these models provides strong evidence that inflation targeting, if adopted, would successfully reduce inflation and at the same time stabilise the Riyal’s exchange rate parities. This would include periods of sustained oil price volatility. In addition, as Saudi Arabia is the core GCC member country the implications of creating a common currency area are tested by using a G-PPP model. Interestingly, the results reveal that GCC countries meet the Optimum Currency Area criteria and therefore a single currency with Saudi Arabia as its base currency/country will be viable. Thus, while fully recognising the political impediments, the main conclusion from a purely economic perspective is that Saudi Arabia should review its current exchange rate arrangements; employ inflation targeting; and lead efforts to create a currency union with the rest of the GCC member countries