This paper examines whether financial innovations have distorted the long-run money demand relationships in the three GCC countries and assesses the implications for the operation of monetary policy in these countries. The paper focuses on the long-run money demand relations since a large and growing body of empirical research has demonstrated that short-run money demand relations are subject to unpredictable changes despite repeated efforts to adjust the estimated equations.
Not surprisingly, financial markets in most developing countries, including those of the Gulf Cooperation Council (GCC), have experienced rapid expansion and deepening in recent years. While financial developments would likely promote high economic growth, fast financial developments may nevertheless hamper the effectiveness of monetary policy that is based on monetary targets. Indeed, in the wake of the fast financial development that several developed countries experienced in late 1980s, evidence emerges suggesting a persistent instability in the money demand relationships in these countries, especially over short periods.
The results suggest the following:
the fast pace of financial developments in the three GCC countries have not caused undue shifts in the equilibrium money demand relationships
all three GCC economies continue to exhibit well-behaving and reliable long-run money demand equations, although simple adjustments in some of these equations are necessary to account for the process of financial innovations
it appears that targeting either M1 or M2 still represents a proper long-run policy strategy in the three GCC countries
the superiority of targeting the narrow measure of money in the UAE, while the evidence for Qatar supports the broad money stock instead
as to Bahrain, both M1 and M2 exhibit reliable and temporally stable equilibrium money demand relations, making targeting either or both monetary aggregates an appropriate guide for monetary policy in Bahrain
Therefore, evidence suggests that monetary targeting is still live and well in the GCC region, and Central Banks in these countries should maintain a close watch on money supply growth as a guide of their monetary policy actions.