An investigation of the relationship among oil revenues, money supply, and the price level in Saudi Arabia

Annual data for Saudi Arabia for the period 1968–1998 were used to investigate the relationship among oil revenues, money supply and the price level. Besides the improvement in the specification of the money demand function in Saudi Arabia, the proposed monetary model in this dissertation differs from those examined in the existing literatures by emphasizing the importance of oil reserves in the money supply process. Most studies in this area have made the implicit assumption that money growth is exogenous and have thus ignored the monetary responses to oil revenues. We identify the main determinants of the money supply and the demand for money in Saudi Arabia, assuming a semi-log form for money demand and continuous equilibrium in the money market. We solve the model for the price level. The model informs the choice of a set of equations for a vector autoregressive model. The baseline model consists of three equations—one each for oil revenues, the money supply and the price level. The data set of only 30 observations dictates that we limit the number of equations. So as not to ignore potentially important relationships, however, we test the robustness of this model by adding other variables, one at a time. The results indicate that non-oil income is an essential part of the Saudi money supply process. Nevertheless, with or without this variable, oil revenue is the driving variable in the system. In addition to the VAR, we estimate a more eclectic price level equation to find out if there is a contemporaneous effect of oil revenues on prices in addition to its indirect effect through the money supply process. The empirical results, which were consistent with those of the VAR model, reveal that the monetary authority in Saudi Arabia follows a counter-cyclical, anti-inflationary monetary policy. Oil revenues have no direct effect on the price level.