## Future of Inflation Rate

Inflation, a persistent rise in prices, affects a country in both positive and negative ways. It needs to be managed so that an economy can function properly. The economy of Saudi Arabia is fully supported by the oil trade and is currently performing above average. The future inflation rate is expected to be quite erratic. For instance, in 2017, the inflation rate is expected to hit a low of 1.98%. In 2018, it is expected to increase to 4.7%. Further, the rate is expected to be stable at 2.04%.

### Purpose of the Paper

The paper seeks to carry out an analysis of the inflation rate in Saudi Arabia. Specifically, the paper will look at the present, past, and future interest rates. Some of the other research questions that the paper will answer are listed below.

- What is inflation?
- What causes inflation?
- How can we measure inflation (what is CPI)?
- What is the relationship between inflation and money supply (monetary policy)?
- What is the role of the Saudi Central Bank (SAMA) about inflation?
- Was the Saudi Central Bank (SAMA) effective at controlling interest rates in the past? What measures have been taken to ensure control?
- What is the historical inflation trend in Saudi (2008 onwards)?

### Research Methodology

The paper will make use of both qualitative and quantitative approaches to answer the research questions. The quantitative approach will make use of numbers, charts, and other statistical approaches such as regression. On the other hand, the qualitative approach will focus on interpreting the data and other numerical figures through objective and subjective analysis.

## Literature Review

Inflation is a scenario where the price level of commodities and services in an economy persistently goes up over a specific period. When a country is experiencing inflation, the purchasing power goes down because a unit of currency buys fewer goods and services. This creates a loss in the value of a medium of exchange. Economies across the globe always try to maintain a stable and low rate instead of negative or zero inflation (Baumann & McAllister, 2015).

Inflation is measured by calculating the inflation rate. It is the rate of change in the price index over time. The most commonly used one is the consumer price index. The consumer price index is a statistical estimate that is built using the prices of a sample of items. The prices of this sample are gathered from time to time. In Saudi Arabia, the consumer price index is majorly made up of food, beverages, renovation, rent, fuel, water, transport, and telecommunication (Bernholz, 2015).

The causes of inflation can be analyzed by looking at the type of inflation. The two types are demand-pull and cost-push inflation. Demand-pull inflation occurs when the economy is near full employment. During this period, a swell in aggregate demand results in a rise in the price level when all other factors are held constant. Some causes of demand-pull inflation are monetary stimulus, high demand for fiscal stimulus, depreciation of the exchange rate, and rapid growth that is experienced in other economies.

On the other hand, cost-push inflation occurs when firms shift the rising costs by increasing prices to protect their bottom lines. Some of the causes of this type of inflation are an increase in the price of raw materials, labor costs, monopoly employers, and increased taxes. In Saudi Arabia, the key factors that affect inflation are external factors such as inflation in trading partners, exchange rate, and high oil prices (Bernholz, 2015).

The price level depends on the money supply in the economy. Thus, there is a direct connection between the rate of inflation and the rate of growth of the money supply. The relationship between inflation and money supply can be explained by the quantity theory of money (Bernholz, 2015). This theory holds that the money supply is equal to the value of all transactions.

- MV = PY
- M = dollars required to make transactions
- V = velocity of money
- P = gross domestic product deflator index
- Y = real gross domestic product

The theory is based on the assumption that the velocity of money (V) is constant. Thus, changes in M are affected by changes in PY. Another assumption is that M does not affect real output (Y). This assumption is because the real output is affected by variables such as the state of the labor market and production function. This implies that a change in M results in a change in P only. This theory suggests that alterations in the money stock (M) would result in a comparative adjustment in P. This implies that if money grows at a high rate, then it will cause higher inflation levels in the economy. Based on this theory, expansionary monetary policies such as borrowing (external and internal) and printing of money cause inflation.

The central bank of the Kingdom of Saudi Arabia is known as the Saudi Arabian Monetary Authority (SAMA) (Saudi Arabian Monetary Authority, 2017). The authority is tasked with performing many functions. Some of the key roles of this agency are managing the monetary policy to retain the stability of exchange rate and prices, printing the national currency, strengthening of the currency, and ensuring that the currency maintains its value (Alkahtani, 2013).

The key drivers of inflation in Saudi Arabia are growth in money supply and government spending. Thus, the monetary policy supports fiscal policy by maintaining price stability. In the past, bank credit had a dismal effect on inflation. Therefore, SAMA did not see the need to regulate bank credit. In recent years, there has been significant growth in bank assets which is a strong indication of financial deepening. This implies that future causes of inflation are likely to be excess credit.

Therefore, SAMA came up with prudential and macro-prudential policies to regulate the availability of credit. In 2008, the country experienced an increase in the inflation rate. The rate was 7.1%. The rate further rose to 11.2% in 2009. Between 2010 and 2016, the inflation rate ranged between 2.19% in 2015 and 4.02% in 2016.

The interest rate decisions are taken by SAMA in Saudi Arabia. The official interest rate is the Official Repo Rate (ORR). In 2008, the benchmark repo rate interest rate was high at 5.5%. However, the country reached a high of 7% in 2000. In the recent past, the interest rate has been at a constant level of 2% (International Monetary Fund, 2017). This shows SAMA has been effective in controlling the interest rates.

## Data Collection

### Inflation Rate

*Table 1: Monthly inflation rate.*

### Inflation Forecasts

*Table 2: Inflation rate forecasts.*

### Interest Rates

*Table 3: Data on interest rate.*

### Money Supply

*Table 4: Data for money supply.*

## Data Analysis

### Analysis of Trend

A review of table 1 and chart 1 show that there was an increase in the inflation rate between January and November 2008. The rise in the inflation rate necessitated SAMA to put in place several measures that were aimed at reducing the rate. The major cause of inflation during this period was the inflationary pressure in other countries due to the global financial crisis. The country experiences a decline in the rate until January 2009.

Between 2009 and December 2015, the country has experienced low levels of inflation. There has also been a general decline in inflation during the same period. However, there was a slight increase in January 2016. Between January and March 2017, Saudi Arabia had negative values of inflation. This implies that the country is experiencing a decline in price levels. Table 2 and chart 2 shows the expected annual inflation rate. A low of 1.98% is expected in 2017 followed by a sharp increase in 2018. A constant rate of 2.04 % is expected in both 2019 and 2020.

Table 3 and chart 3 displays the trend of both the repo rate and the deposit rate. Since May 2009, SAMA has maintained the repo rate at a constant rate. The deposit interest rate was also low with a slight increase between September 2015 and May 2016. Table 4 and chart 4 shows that there has been a continuous increase in money supply in the economy as measured by M1, M2, and M3. Based on the quantity theory of money, it is expected that as the money supply increases, then the rate of inflation should also go up. However, this is not the case as can be seen in the trend of the inflation rate.

### Descriptive Statistics

*Table 4: Summary of descriptive statistics.*

### Correlation

*Table 5: Correlation results.*

The correlation results show that there is a strong positive relationship between the repo rate and the inflation rate. Also, there is a negative relationship between inflation and other variables.

### Regression Analysis

A multiple regression analysis will be carried out to analyze the association between the three variables. The regression result will take the form presented below.

Y = X1I_{1} + X2I_{2} + X3M1 + X4M2 + X5M3

Where;

- Y = inflation rate;
- X1 (I
_{1)}= Repo rate; - X2 (I
_{2}) = Interest rate on bonds; - X3 (M1) = Money stock /supply;
- X4 (M2) = Money stock / supply;
- X5 (M3) = money stock / supply.

*Table 6: Regression results.*

Based, on the results above, the regression equation will take the form Y = 0.1107 + 0.01904 X_{1} + 0.0269 X_{2} + 1.03161E-13X_{3} – 8.26203E-14X_{4 }– 5.68613E-14X_{5}.

The intercept is 0.1107. It has no significant statistical interpretation. It simply shows the variables that have not been included in the regression equation. The positive coefficient values for repo interest rate, the deposit interest rate, and M1 imply that their inflation and these three variables move in the same direction. If the variables change by one unit, then inflation will change by the value of the coefficient. On the other hand, M2 and M3 have a negative coefficient. It implies that there is an inverse relationship between these two variables and inflation. If M2 and M3 increase by one unit, then inflation will drop by the value of the coefficient.

The coefficient of determination (R-square) is 0.8599. The value shows that 85.99% of the variations in inflation is explained by the five variables. It is an indication of a strong explanatory variable. The value of an adjusted R-Square is also high at 0.8531.

Another area that can be analyzed in the regression results is the significance of the explanatory variable. This can be done by looking at the p-value and t-statistic. The t-statistics will be compared with the significance level of 5%. If the p-value is less than the level of significance, then the variables will be statistically significant at the 95% confidence level. From the table, the p-values for repo rates (8.69E-19), interest rate on government securities (2.34E-06), and M1 (0.001181) are less than the significance level.

This implies that they are statistically significant at the 95% confidence level. On the other hand, the p-values for M2 (0.20796) and M3 (0.3945) are greater than 0.05. Therefore, the two variables are not statistically significant at the 95% confidence level.

The final area that will be analyzed in the regression result is ANOVA. It is used to test the significance of the entire regression line. This can be achieved by evaluating the F-values. From the table, F-statistic is 127.63, while significance F is 9.76223E-43. This value is lower than the significance level of 0.05. This implies that the overall regression line is significant at the 95% confidence level.

Thus, the statistical analysis indicates that the regression is significant and can be relied upon. Thus, inflation is a strong determinant of GDP. However, M2 and M3 can be dropped from the regression equation because they not statistically significant. The results indicate that the interest rate and M1 affect inflation in Saudi Arabia. M1 comprises of physical money, checking accounts, negotiable order of withdrawal accounts, and demand deposits. Therefore, if SAMA wants to control inflation in the country, then they should come up with measures that target these variables.

## Conclusion

The paper carried out an analysis of the past, present, and future inflation rates in Saudi Arabia. The objectives of the paper were to understand inflation, measures of inflation, the causes of inflation, the relationship between inflation and money supply, the role of SAMA, and the effectiveness of SAMA in controlling interest rates. The paper made use of both quantitative and qualitative approaches to answer the research objectives.

From the analysis, it can be deduced that inflation is a persistent rise in price levels in the economy that are caused by demand-pull and cost-push factors. Besides, it is measured using the consumer price index. Further, the quantity theory of money is used to explain the relationship between money supply and inflation. The theory suggests that there is a direct association between money supply and inflation. The discussion above also indicates that SAMA has successfully controlled the interest rate. The inflation rate was high in 2008. The values dropped between 2008 and 2015. Thereafter, the values rose again. In 2017, the inflation rates in the country were negative.

The regression results show that the repo rate, deposit interest rate, and M1 are the statistically significant variables that affect inflation. However, M2 and M3 are not significant determinants. Therefore, M2 and M3 can be dropped from the regression equation and other variables can be added. The positive relationship between inflation rate and M1 confirms the quantity theory of money, which states that there is a positive association between inflation and money supply. Also, the positive relationship between inflation and interest rate indicates that bank credit affects the inflation rate. Therefore, it is important for the regulatory authority to closely monitor bank credit.

## References

Alkahtani, K. J. (2013). *The effects of the fiscal policy on economic activity in Saudi Arabia: An empirical analysis*. Web.

Baumann, D. & McAllister, L. (2015). *Inflation and string theory* (1^{st} ed.). Cambridge, UK: Cambridge University Press.

Bernholz, P. (2015). *Monetary regimes and inflation: History, economic and political relationships *(2^{nd} ed.). Cheltenham, UK: Edward Elgar Publishing Limited.

International Monetary Fund. (2017). *Data*. Web.

Saudi Arabian Monetary Authority. (2017). *Inflation rate*. Web.