Monetary volatility and the dynamics of economic growth: An empirical analysis of an oil‐based economy, 1970–2018

• Published date: 01 March 2023
• Author: Abdulaziz Hamad Algaeed,Basmah S. Algethami
• Date: 01 March 2023
• DOI: http://doi.org/10.1111/opec.12235

OPEC Energy Rev. 2023;47:3–18.

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wileyonlinelibrary.com/journal/opec

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INTRODUCTION

Throughout the years of economic development, Saudi Arabia has controlled the stability of its economy through pru-

dent fiscal policy and frugal monetary policy. More recently, fluctuations in oil prices have shaken the sources of spend-

ing in all parts of the economy to. In the past, monetary policy and theories of economic growth have been characterised

by dissimilarities, ambiguities, inconclusiveness and cross- currents (Twinoburyo and Odhiambo, 2018a, 2018b). The

role and power of monetary policy have been extensively discussed in the literature. Dimitrijević and Lovre (2013) in

DOI: 10.1111/opec.12235

ORIGINAL ARTICLE

Monetary volatility and the dynamics of economic growth:

An empirical analysis of an oil- based economy, 1970– 2018

Abdulaziz HamadAlgaeed1

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Basmah S.Algethami2

1Human Rights Commission (HRC),

Commission’s Board Member, Riyadh,

Saudi Arabia

2Department of Economics, Imam

Mohammad bin Saud University,

Riyadh, Saudi Arabia

Correspondence

Abdulaziz Hamad Algaeed,

Human Rights Commission (HRC),

Commission’s Board Member, Riyadh,

Saudi Arabia.

Email: Ibngaeed@outlook.com

Abstract

Over the past decades, and since the first development plan in 1970, Saudi Arabia

has controlled the stability of its economy through prudent fiscal policy and tight

monetary policy. This study examines the impact of monetary volatility on real

gross domestic product (GDP) growth in an oil- based economy from 1970 to 2018,

using the Hodrick– Prescott filtering approach. Although standard methods such

as GARCH are used to test volatility, the uniqueness of this study is that it tests

the volatility of monetary policy using ordinary least squares (OLS), autoregres-

sive distributed lag (ARDL) and IRF methods. We find that the standard devia-

tion of the broad money supply and the real interest rate business cycle tends

to have a negative impact on real growth in the short and long run, supporting

the proposition that a high interest rate negatively affects real growth. We also

document that the standard deviation of the real exchange rate business cycle

has a positive (negative) effect on real growth in the short and long run and is

not statistically significant. This suggests that the volatility of the real exchange

rate does not affect real growth. Moreover, the magnitude of the volatility of the

coefficients is lower in the long run than in the short run. To achieve sustainable

economic growth, policy makers need to plan how to manage the volatility of the

money supply and the interest rate in the short run and develop long- run strate-

gies to manage volatility in the long run. To control monetary volatility, policy-

makers should also control government spending by dampening the volatility of

oil prices, which ultimately affect the money supply and thus stable economic

growth.

This is an open access article under the terms of the Creative Commons Attribution-NonCommercial License, which permits use, distribution and reproduction in any

medium, provided the original work is properly cited and is not used for commercial purposes.

© 2022 The Authors. OPEC Energy Review published by John Wiley & Sons Ltd on behalf of Organization of the Petroleum Exporting Countries.

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ABDULAZIZ HAMAD ALGAEED and BASMAH S. ALGETHAMI

a comprehensive review of the literature, found that money supply is the most important instrument for a functioning

monetary policy and that a low interest rate is the key factor in maintaining a stable velocity of circulation, which af-

fects growth in the short and long run. Meanwhile, less attention is paid to GDP growth than to monetary and financial

stability. Monetary policy is less effective in stimulating aggregate demand and output for reasons such as headwinds

that occur in the wake of balance sheet recessions when the interest rate is low, and nonlinearities that occur when the

interest rate is low and overcome the effect of spending (Borio and Hofmann, 2017). Under fixed exchange rate assuming

an ‘open’ capital market and some institutional constraints, Gong and Gao (2008) argue that not only for an effective

monetary policy but also for a fixed exchange rate that strengthens macroeconomic stability for both domestic and trad-

ing partners.

This study focuses on the short and long run effects of monetary volatility on real GDP growth (GRt) in Saudi Arabia

as a major oil producer. Primarily, the volatility of monetary policy instruments on economic growth is examined in de-

tail using various measures (OLS, ARDL and IRF). According to Werner and Lee (2018), there is a positive relationship

between the three- month to ten- year interest rate benchmark and nominal GDP growth in four advanced economies, the

United States, the United Kingdom, Germany and Japan. These results refute the assumption that a lower interest rate

leads to an increase in growth. On the contrary, contractionary monetary policy (interest rate) has a negative impact on

economic growth (Mallick and Sousa, 2009).

This paper raises the following question: Does monetary volatility affect the stimulation of real economic growth in

Saudi Arabia?

The answer to this question is twofold. Firstly, Saudi Arabia is one of the largest oil producing countries, and it will be

interesting to see how real GRt responds to monetary volatility given its dependence on an unsteady source of income.

Secondly, the authorities need to address the long- term exchange rate in order to conduct an effective monetary policy

in Saudi Arabia. In this context, the Saudi Central Bank (SCB) can change reserve requirements, adjust bank lending

guidelines and change the interest rate (repo rate). In other words, the SCB can resort to various instruments to achieve

the country’s economic goals. For example, the SCB’s 1957 charter (Article 1), which regulates the issuance of the Saudi

national currency, the riyal, is the basis for maintaining the riyal’s strength at home and abroad, and for limiting com-

mercial banks and foreign exchange dealers. In addition, the SCB has recently started monitoring insurance companies.

This study examines the effects and consequences of monetary volatility on real economic growth by empirically test-

ing the effects of volatility of monetary instruments, broad money supply, real interest rate and real exchange rate on real

output growth in Saudi Arabia. The hypotheses are as follows. The volatility of broad money supply (MS2t) has a negative

effect on the level of output, the volatility of the real interest rate (USRt) has a negative effect on output and the volatility

of the real exchange rate has a positive effect on the level of output.

The motivation for this paper is as follows. Firstly, it is the first paper to examine the effects of monetary volatility

measures, broad money supply (MS2t), real interest rate (USRt) and real exchange rate (EXt) on real GRt in a large open

and oil- based economy for the period 1970– 2018. Secondly, this paper provides important evidence on growth dynamics

in Saudi Arabia. Thirdly, the results obtained are consistent with the findings in the economics literature. On the other

hand, volatility of credit to the private sector (CRt) and volatility of trade openness (TOt) are included as control variables.

Although numerous studies have examined various aspects of the Saudi economy (Said, 2019), to our knowledge,

there is no in- depth empirical analysis of monetary volatility and its impact on real output growth. To fill the existing gap

in the literature, this study is completely different from other studies in terms of understanding the impact of monetary

volatility on real economic growth. To this end, this paper employs various econometric methods. This valuable analysis

is an attempt to fill the gap in the literature.

The results of this study will benefit policy makers, researchers and others interested in understanding the impact of

monetary volatility on growth dynamics in the context of a major oil producing country. Our findings in this study are

as follows. The volatility of broad money supply and real interest rate has a negative impact on real GRt in the short and

long run, while the volatility of real exchange rate has a positive (negative) impact on real GRt in the short and long run.

Figure 1 shows the evolution of the real growth rate as a function of real credit to the private sector, the real interest

rate, the real exchange rate, broad money supply MS2t and trade openness. It is worth noting that with the exception of

the US real interest rate, which is used as a proxy for the Saudi interest rate, the fluctuations in the variables only begin

to follow the fluctuations in the real GRt, as the real growth rate reflects the fluctuations in the main source of revenue,

namely oil revenues.

The rest of this paper is organised as follows. Section 2 reviews the theoretical and empirical literature on the effec-

tiveness of monetary policy and its impact on economic growth. Section 3 discusses the ordinary least squares (OLS),

autoregressive distributed lag (ARDL) and IRF models. Section 4 presents the estimation of the OLS and ARDL models,