The relationship between inflation and financial development in Saudi Arabia

Abstract

The improved performance of the financial sector through its process of financial intermediation between savers and investors and between lenders and borrowers as well as the guidance of the funds those are available to the optimal investments lead to achieve the desired stable economic growth. Economists generally believe that high rates of inflation cause problems to some individuals and as well as for the whole economic performance. In general, low inflation rate with financial sector development plays a crucial and essential role in achieving sustained and stable economic growth. Therefore, maintaining inflation rate at low level and improving the financial sector performance are considering themain targets for policy makers to promote sustained and stable economic growth. So, the main purpose of this paper was to investigate empirically the relationship between inflation and financial sector development in Saudi Arabia for the period of 1982-2013.This paper used the autoregressive distributed lag (ARDL) bound testing approach suggested by Perasan et al. (2001) to examine the existence of the long-run relationship between the inflation rate and financial sector development. The advantage of the bounds testing approach is in its applicability irrespective of whether the underlying variables are purely I (0), purely I (1) or mutually co-integrated.All data were tested for stationarity using Augmented Dickey-Fuller (ADF) test and the Phillip-Perron (PP) test to determine the order of integration. The variables included in this study are: The credit to the private sector as percentage of GDP was used as a proxy of financial development and inflation rate measured by the consumer price index. The study also included two more control variables: trade openness and real gross domestic product. The main findings are as follows. First, tests results of the Augmented Dickey-Fuller (ADF) and Phillips – Perron (PP) showed that consumer price index (LCPI), real gross domestic product (LGDP) and trade openness (LOPEN) did not seem to be stationary at their level but they were at first difference. Accordingly, they were integrated of order one I (1). On the other side, both tests results of financial development (LFD) seemed to be stationary at its level. Accordingly, it was integrated of order zero I (0). Second, results showed that there was a statistically significant long-and-short run negative relationship between inflation and financial development. Third, there was statistically significant positive impact of previous financial sector’s policies on financial sector development.Forth, results indicated that there was statistically significant positive impact of economic growth on financial development. Fifth, there was a statistically significant negative impact of trade openness on financial development.Accordingly, inflation and trade liberalization policy are the main obstacles facing financial sector performance. Therefore, the policy makers can reduce inflation through the use of appropriate fiscal and monetary policies.