Conference Paper

Financial Stability and Monetary Policy Reaction: Evidence from the GCC Countries


March, 2021


G. Financial Economics

E. Macroeconomics and Monetary Economics

The 2008 global financial turmoil and resultant slowdown in economic activities spurred economists to revisit the debate on the efficacy and future of monetary policy. Many had argued that expansionary monetary policy had laid the grounds for the downturn. For instance, Taylor (2007) noted that the short-term interest rate path had deviated considerably between the years 2002 and 2005 from the observed short-term interest rates of the Great Moderation period. Markedly, low interest rates had prompted financial institutions to over-leverage in order to reap high returns on risk capital. Recently, the outbreak of the coronavirus disease 2019 (COVID-19) pandemic created a strong contagion effect across global financial markets, leading to an immediate economic downturn and unprecedented levels of economic uncertainty. Financial markets have witnessed a sharp decline in the prices of financial assets, a deterioration in market liquidity and volatility spikes (Gopinath, 2020). Consequently, academic literature examining the responses of various financial assets and markets to the pandemic is rapidly emerging (see, e.g. Akhtaruzzaman et al., 2020; Corbet et al., 2020; Demir et al., 2020; Goodell and Goutte, 2020; Liu et al., 2020; Sharif et al., 2020; Yarovaya et al., 2020; and Zhang et al., 2020). Empirical evidence also suggests that the marginal effects of financial conditions on output and inflation become less clear when the economy is recovering or expanding (Bech et al., 2014). It is likely that this state-contingent effectiveness of monetary policy is also at play in current times. A key point at issue that emerged out of this dialogue is about the nature of the relationship between monetary policy and financial stability. Monetary policy and financial stability follow a complicated and conflicting relationship and an enormous body of literature has tried to observe these dynamics but the outcomes remain inconclusive e.g. Driffill et al., (2006); Granville and Mallick (2009); Albulescu et al., (2013); Camlica (2016); Nasreen and Anwar (2019). Thus, the objective of this study is to analyze the interaction between monetary stability and financial stability in GCC countries by introducing a financial stability index to monitor the financial vulnerabilities and crisis. Our study makes two core contributions to the existing literature. First, we develop a composite index of financial stability that provides a more comprehensive and complete view of the financial condition of GCC countries. Second, to the best of our knowledge, this is the first paper to investigate whether the monetary authority gives any attention to the financial stability in pursuing monetary policies in GCC economies. For this purpose, monetary policy reaction functions are estimated for each of the GCC country namely, Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates. Furthermore, this study will try to give some answers to the following question: Could we consider the financial (in)stability index as an efficient approach to predict the financial crises? Do financial instabilities have an impact on monetary policy in GCC countries? Does the monetary policy have the same effect on financial stability in the low financial stress regime and in the high financial stress regime?
Financial Stability and Monetary Policy Reaction: Evidence from the GCC Countries

Research Fellows

Ahmed Elsayed

Associate Professor of Financial Economics, United Arab...

Financial Stability and Monetary Policy Reaction: Evidence from the GCC Countries


Nader Naifar

Professor of Finance College of Economics and...

Financial Stability and Monetary Policy Reaction: Evidence from the GCC Countries


Samia Nasreen

Associate Professor, Department of Economics Lahore College...