Chapter 2: Bahrain
Bahrain is a small country with a highly open economy. It operates under a fixed peg exchange rate system with freely mobile capital. Among the rapidly growing economies of the Middle East, Bahrain’s importance has been increasing given its long standing as a global centre for international banking and finance. Bahrain has indeed emerged as a leader in Islamic banking and finance since the late 1970s. Presently, it represents an important case study of exchange rate policy for economic stability in general and price stability in particular within a composite banking and financial system. This chapter overviews the financial system in Bahrain and examines the operation and consequences of exchange rate policy for price and real exchange rate stability. The core feature of exchange rate policy in Bahrain has been in place since the early 1980s. A fixed peg exchange rate system fixes the Bahrain dinar to the US dollar while international capital flows are deregulated, yielding perfect capital mobility. Therefore, aspects of macroeconomic performance in Bahrain can be highlighted to assess the implications of a fixed peg exchange rate system on the following key variables: the inflation rate; the real interest rate; the real exchange rate; and real output growth.
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