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Monetary Policy
Assessment of Key Issues
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| Project on Assessment of Key Issues Related to Monetary Policy Module: 7 Monetary Transmission Mechanism Financial Stability: International Experience Monetary stability commonly refers to stability of the price level (or its rate of change, inflation), the inverse of the value of money in terms of a basket of current goods. Price stability is often thought of as an environment where inflation does not materially affect economic decisions. Such an environment promotes efficient allocation of resources and has led to stable macroeconomic conditions in many countries. Price stability refers not to individual prices, but prices of an aggregate 'basket' of consumer goods and services that can be summarised into a single index. In this respect, price stability - whether formalised in terms of an explicit inflation target or otherwise - is considered to be relatively well understood, transparent and measurable. Financial stability, on the other hand, is not tractable to any commonly agreed definition. Indeed, financial stability is often thought of as the absence of financial instability - such as a banking crisis or even extreme financial market volatility - which can have severe macroeconomic consequences for countries experiencing such episodes. Officials, central banks and academics have proposed a myriad of definitions of financial stability (Box VIII.1). As Box VIII.1 elucidates, the concept of financial stability is nebulous, with no commonly accepted definition. Some have defined it in terms of what it is not: a situation in which financial instability impairs the real economy, owing perhaps to informational asymmetries. Others adopt a macro prudential viewpoint and specify financial stability in terms of limiting risks of significant real output losses associated with episodes of system-wide financial distress.
The challenge of reaching a working definition is exacerbated by difficulties in measurement. Price stability is easily quantifiable in terms of a measure. Financial stability, in contrast, cannot be summarised in a single measure: a financially stable system depends as much on the health of financial institutions as it does on the complex inter-linkages between those institutions and the interplay between the financial system, the real economy and financial markets. Apart from definitional issues, there is the issue of instruments. While price stability can be achieved through modulations in short-term interest rates - an instrument under the central bank's control - central banks lack any such single instrument to achieve the objective of financial stability. As a consequence, the instruments and institutional arrangements employed to pursue the financial stability objective are much more varied than for price stability. In most countries, financial stability policy consists of a number of elements designed to improve the resilience of the financial sector to unexpected developments and to respond should they spill over into a financial crisis. These policies include: prudential regulation and supervision, promotion of sound payment and settlement architecture, appropriate corporate governance and accounting standards and a robust legal framework. The nature of these instruments means that they are often difficult to adjust in a timely fashion in response to a shock, an issue which is often complicated by these instruments being under the domain of different authorities. Before a discussion of these policy responses is undertaken, a review of various theories of financial crises would be useful. This is taken up in the next article. | |
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