Monetary policy, exchange rates and stock prices in the Middle East

region

A debate occurred between academics and policy makers about whether the
monetary policy should respond to the development in the financial market those
who support the idea of a proactive monetary policy to the assets price boom and
bust that these fluctuation cycle could deteriorate investments and consumption
decisions and result in more fluctuation in output and inflation they suggest the
monetary policy which will be adopted to follow the strategy of lean against the wind
which mean that increasing and decreasing interest rates at the time there is rising
and falling in asset prices in order to maintain economic stability

Also another point of argue is the difficulties the monetary authorities in anticipating
the asset prices misalignments and whether they are able to bring the prices back or
not Accordingly, monetary policy should follow a reactive approach where the
authorities wait and see whether asset price reversals occur, and react in an ex post
accommodative manner to the extent that these reversals affect output and inflation
stability

This study investigates the relationship between monetary policy and stock prices in
five emerging Middle Eastern economies; Kuwait, Oman, Saudi Arabia, Egypt and
Jordan. The reason of choosing these countries that the studies that have been made
before and the information gather were very scarce these studies was focusing on
the main traditional monetary transmission mechanism which is interest rates and
bank lending channels
Monetary policy and asset prices

1- Monetary policy and stock prices

There is a general agreement among economists that monetary policy plays an

important role in the stock prices movement which occur through two main channels

 Increasing interest rates result in lower stock prices

 The impact of the contracting monetary policy on the real economic activity
and affecting the future earning potential of the firms

The main focus of monetary policy is to respond to actual and forecasted inflation
and the output gap in order to minimize economic fluctuations. However there are a
number of reasons why monetary authorities may consider asset prices in general
and stock prices in particular when setting monetary policy

 Stock prices play an important role in the transmission of monetary policy

 Information in stock prices is used by central banks when formulating the
monetary policy
2- Monetary policy and exchange rates

Monetary policy has a direct impact on exchanges rates where a contractionary

policy that increases domestic interest rates makes domestic currency deposits more
attractive than foreign currency deposits. This leads to an inflow of capital

3- Stock prices and exchange rates

The relationship between stock prices and exchange rates is not as straightforward
as between these financial variables and monetary policy. There are two main
models that attempt to determine exchange rate and stock price interactions, flow
oriented models and the stock oriented model

Flow models emphasize the role of exchange rates in determining the international
competitiveness of exporting firms. For instance an appreciation of the domestic
currency would make exports more expensive and thus less competitive reducing
foreign demand and firm's earnings, and consequently its value which will be
reflected in a lower stock price.

On the other hand stock models stress on the role stock markets play in determining
capital flow movements. A rise in domestic stock prices can attract portfolio inflows
increasing the demand on the domestic currency and causing it to appreciate

Results of the study

1- Monetary tightening leads to a fall in stock prices in all countries although

with different dynamics and magnitudes. It was significant in Kuwait and
Egypt and not in the other three countries Jordon , Oman and Saudi Arabia
as the first two countries have an independent monetary policy which allow
for more flexible exchange rates
2- real exchange rate can significantly affect stock prices, although the
direction of the impact depends on the type of firms export or import
oriented
3- An increase in the stock prices leads to an appreciation of the real exchange
rate
4- An increase in stock prices leads to an increase in output and inflation.
 SWOT analysis of the article

Strength:

 The important role of monetary policy in the stability of the economy

 The relationship between monetary policy , stock prices and exchange rates

Weakness

 There is still not enough information that will help to formulate a complete
framework of the relation between monetary policy , stock prices and
exchange rates in the Arabian countries

Opportunities

 Developing the stock markets in the Arabian countries will have an essential
role in transmitting monetary policy shocks to the rest of the economy
 Having an independent monetary policy allow more flexible exchange rates

Threats

 Financial crises have a great impact on the economy especially assets prices
without a proactive monetary policy this might affect the economy of the
country
Conclusion

Countries should focus on their monetary policy which is an important key player in
the stability of the economy and the first defense toward facing financial crisis that
the world might face , central bank should develop an independent monetary policy
like what Egypt do when trying to face the effect of the global financial crises the
occur in 2007 and there should be a focus on developing and growing the stock
market which will have a great impact on the aggregate demand through the asset
price channel of the monetary transmission mechanism.