Financial Stability and Monetary Policy Reaction Evidence from the GCC Countries

Abstract

This paper investigates the interaction between monetary policy and financial stability in the Gulf Cooperation Council (hereafter GCC) countries by introducing a new composite financial stability index to monitor the financial vulnerabilities and crisis periods. To this end, the study estimated monetary policy reaction functions for each of the GCC countries (namely, Bahrain, Kuwait, Saudi Arabia, and the United Arab Emirates) using the Nonlinear Autoregressive Distributed Lag Model (NARDL) over the period from 2006-Q4 to 2020-Q2. Empirical findings indicate that monetary authorities' response to the deviation of inflation from their target level, output gap, or exchange rate movement differ in terms of magnitude, sign, and significance across the GCC countries. The results further explain that monetary authorities react significantly to negative or positive shocks in financial stability, but their reaction is different in the short-run or long run. Overall, an augmented Taylor rule including financial stability as an additional monetary policy objective is more appropriate for the GCC countries.