The impacts of oil price on exchange rates: Evidence from Saudi Arabia

Abstract

The real exchange rate is a key indicator of a country’s trade competitiveness in the world. This paper investigates the interaction between oil price and real exchange rates in Saudi Arabia during the period January 1986 -March 2019, using monthly data. This study uses the autoregressive distributed lag model and the error correction model in order to investigate the existence of a long-run equilibrium relationship between the variables. The evidence reveals that there is a strong long-run cointegration. The robustness of the autoregressive distributed lag bounds test cointegration was confirmed using the newly developed combined cointegration, which also provided the same evidence for a strong long-run relationship. In the short term, the results confirm the existence of a unidirectional causal relationship ranging from the oil price to the exchange rate. In the long term, however, the causal relationship is bidirectional between these two variables. An appreciation of the Saudi exchange rate generates an increase in the relative demand for oil, which in turn creates upward pressure on its price. For policy purposes, such evidence suggests that Saudi Arabia should be careful not to put too much weight on the benefits of higher revenue due to higher oil price.