Uncovered interest parity and adjustments in the money market: the case of the Kingdom of Saudi Arabia

Abstract

This paper investigates the relationship between short-tenn interest rates in the Kingdom of Saudi Arabia and the Dollar interest rate, which closely follows the Eurodollar rate in international markets. The issue is important for understanding the determination of interest rates in a local economy; whether they are determined according to forces in the money market or via a simple reaction function perhaps dependent on an interest parity condition. The issue also has some bearing on the adjustments undertaken in the local money market whether they tend to fall on money supply or money demand. The paper initially considers Granger causality tests to detennine the direction of causation between the two variables and then extends the analysis by incorporating a full-fledged interest rate parity relationship. Results, however, indicate that the determination of local interest rates might be in accordance with a simple reaction mechanism. Since interest rates are exogenously detennined and the money supply appears to be sTable, the bulk of adjustments in local money markets would tend to fall on the money demand function.