Monetary policy and the financial sector's role in economic development: A case study of Saudi Arabia

There are two schools of thought on the role of finance in the process of economic development, the financial structuralist and the financial repressionist schools. Even though their approach to achieving financial deepening differs, both schools argue for higher domestic savings for the purpose of investment. The financial structuralists favor the spread of financial institutions and greater diversification in financial instruments. The financial repressionists, on the other hand, argue in favor of controlling the inflation rate and freeing the interest rate as necessary steps to achieving financial deepening and economic growth.;Saudi Arabia has a relatively underdeveloped financial market and the capital market and private investment banks are non-existent. Thus, the contribution of the financial sector to the economic growth that Saudi Arabia witnessed in the last two decades is believed to be very small. This growth was fueled by the revenue generated from the sale of oil to foreigners. The danger of such a policy is the high level of dependence on the revenue of one depletable resource.;Due to the nature of the Saudi economy, the effects of fiscal and monetary policies are almost identical, making it difficult for the Saudi Arabian Monetary Agency to conduct monetary policy when needed.;For Saudi Arabia to maintain its economic growth a combination of developed financial and capital markets and an effective monetary policy are needed. In addition to identifying monetary tools that are consistent with Islamic law, the purpose of this study is to attempt to answer some unresolved questions regarding finance and economic growth in economic development, particularly in Saudi Arabia.;A finance model with 22 equations is developed for Saudi Arabia. This model incorporates the financial repressionist and structuralist arguments along with the unique features of the Saudi economy. The focus is on how Saudi Arabia can achieve financial deepening and reverse capital outflow from the Kingdom. The model was estimated using annual data from 1966-1988. The regression results lend strong support to the financial repressionist school. The results of the policy simulation support the effectiveness of the alternative monetary tools proposed in this study.