Financial Stability, Economic Growth, Inflation And Monetary Policy Linkages In India: An Empirical Reflection
Author(s) Sarat Dhal, Purnendu Kumar, Jugnu Ansari Publication Reserve Bank of India Occasional Papers


Economic growth and inflation are often used to characterize economic stability and monetary or price stability. This study provides an empirical assessment of crucial issues relating to the linkages of financial stability with economic growth and inflation in the Indian context. For this purpose, the study uses vector auto-regression (VAR) model comprising output, inflation, interest rates and a banking sector stability index. The banking stability index is constructed with capital adequacy, asset quality, management efficiency, earnings and liquidity (CAMEL) indicators. Our empirical investigation reveals that financial stability on the one hand and macroeconomic indicators comprising output, inflation and interest rates on the other hand can share a statistically significant bi-directional Granger block causal relationship. The impulse response function of the VAR model provides some interesting perspectives. First, financial stability, growth and inflation could share a medium-longer-term relationship. Second, enhanced financial stability could be associated with higher growth accompanied by softer interest rates and without much threat to price stability in the medium to long term. Third, greater economic stability or higher output growth can enhance financial stability. Fourth, higher inflation or price instability could adversely affect financial stability. Fifth, financial stability can contribute to the effectiveness of monetary transmission mechanisms. Finally, with financial stability, output growth could become more persistent and inflation less persistent.

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