Financial Stability and Monetary Policy Reaction Evidence from the GCC Countries
2021
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.
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