FINANCIAL STABILITY AND MONETARY POLICY REACTION FUNCTION FOR SOUTH ASIAN COUNTRIES: AN ECONOMETRIC APPROACH

Abstract

This study empirically investigates a monetary policy reaction function for South Asian economies by incorporating financial stability as an additional policy objective in the central bank’s loss function. Empirical results are estimated by applying auto-regressive distributed lag (ARDL) approach to cointegration and vector autoregressive (VAR) approach using time-series data of five South Asian countries, namely, Pakistan, India, Bangladesh, Nepal and Sri Lanka. Estimated results indicate that monetary policy significantly reacts to the level of financial stability in all countries. The result further suggests that central banks would tighten monetary policy if output gap widens and exchange rate depreciate. In addition, central banks of Pakistan and India do not respond significantly to inflation gap.