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Financial Stability

Updated on April 4, 2024
Article byPrakhar Gajendrakar
Edited byPrakhar Gajendrakar
Reviewed byDheeraj Vaidya, CFA, FRM

Financial Stability Meaning

Financial stability is when a business, individual, or nation cannot withstand external imbalances in financial markets. A stable financial system mitigates sudden fluctuations in the global market and local economy. Self-correcting mechanisms achieve this.

Financial Stability Indicators

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Economic stability leads to sustainable economic growth, price stability, and reduced unemployment. On the other hand, when a nation fails to maintain economic stability, it experiences inflation, recession, and stock market crashes. Therefore, the central bank uses various tools like expansionary monetary policies, fiscal policies, and interest rates to regulate economic stability.

Key Takeaways

  • Financial stability defines the financial system of a country based on the availability of resources, utilities, loans, and employment opportunities.
  • Economic stability is measured using GDP, inflation, fiscal deficit, trade deficit, interest rates, employment levels, income inequality, and cash flows.
  • A stable economy can spend more on its citizens—free education, health care, sanitation, public transport, and infrastructure.
  • Economic stability has a direct impact on the individual standard of living. Therefore, economists use per capita income to gauge economic stability at the individual level.

Financial Stability Explained

Financial stability is a scenario where a business, individual, or nation can prevent and withstand external imbalances in financial markets. A stable financial system mitigates sudden fluctuations in the global market and local economy. Thus, economic stability refers to self-corrective mechanisms that do not let changes disrupt an economy.

An economy is considered financially stable, with a constant flow of funds; banks and financial institutions operate smoothly. Ideally, the government must maintain adequate national reserves to ensure a stable economy.

At the microeconomic level, the economic stability of a particular business depends on the easy availability of loans and investment opportunities—financial instruments—the condition of the stock market. Further, at the individual level, economic stability greatly relies on resource allocation. A financially stable government allocates resources and services to individuals and households in an efficient manner.

The level of Inflation, national debt, and employment are primary indicators of economic stability. Therefore, India established a Financial Stability Development Council (FSDC) to control those parameters in 2010. The FSDC oversees India’s economic development and economic stability. It directly reports to RBI (central bank).

Similarly, the IMF releases a semiannual assessment twice a year—The Global Financial Stability Report (GFSR). It is an analysis of global systems and global markets. Specifically, it focuses on current market conditions, systemic issues, and emerging borrowers.

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Measures

Let us look at some financial stability measures.

  • The central bank prioritizes inflation rates. It takes prompt action to control inflation and to ensure a healthy pricing model in the local market.
  • The government is responsible for the optimum allocation of resources and services.
  • Using expansionary monetary policies, the central bank maintains a perpetual influx of cash in capital markets (foreign and domestic investors).
  • For rapid growth, a country must capitalize on emerging markets; international diplomacy must promote global trade.
  • A growing economy tries to maintain and elevate the gross domestic product.

Examples

Let us look at some examples of financial stability examples.

Example #1

Ryan stars a company that manufactures plastic pipes. Initially, he took a bank loan for working capital.

Within a year, the firm generates a net profit of $900,000. Ryan is cautious about loan repayments. Nevertheless, he makes all his periodic loan payments on time. By the second year, Ryan’s firm doubles its net profit to $180,0000. Ryan is almost done with loans and wishes to expand. In addition to healthy profits, the firm also exhibits perpetual cash flow and liquidity.

For expansion, Ryan launches an IPO. Investors compare the firm’s financial ratios and notice growth potential.

Example #2

In 2022, there was a sudden fall in Sri Lanka’s financial stability. A delay in debt restructuring caused the shocking predicament. In addition, the country experienced record-low foreign exchange reserves. As a result, citizens struggled to afford essential imports like fuel, cooking gas, food, and medicine.

Sri Lanka owes China over $1.7 billion. Many world authorities have been facing repayment issues with Sri Lanka. The economic stability of a nation is fragile; minor mismanagement can send an economy into a tailspin.

Importance

Now, let us look at the importance of financial stability.

  • More employment opportunities – To ensure a steady economy, everyone needs to contribute—the government, businesses, and citizens. In addition, economic stability increases the demand for labor and triggers a rise in employment opportunities.
  • Increased public expenditure – A stable economy can spend more on its citizens—free education, health care, sanitation, public transport, and infrastructure.
  • Improved living standards – Economic stability directly impacts the individual standard of living. Therefore, economists use per capita income to gauge economic stability at the individual level.
  • Income inequality – Unlike GDP, income inequality often goes unnoticed in a country. But a stable economy also focuses on equal distribution of income and wealth.
  • Attracts FDI – Foreign investors prioritize stable economies for investments. Therefore, it is a safe bet.

Financial Stability And Monetary Policy

  • Financial stability is all about growth and the overall positioning of the economy. In comparison, monetary policies target inflation.
  • Economic stability establishes a system that covers all aspects of an economy— including the business and public sectors. On the other hand, the monetary policy narrows down on policy rates, regulation, and inflation projections.
  • The term economic stability refers to a system. In contrast, monetary policy is a tool used to control the system—it is used to maintain financial instruments.

Financial Stability And Economic Growth

  • Economic stability covers all the stages of growth. In contrast, the term economic growth predominantly refers to the total economic development of a country—using absolutes and metrics like GDP.
  • Economic stability is a generalized concept; it includes jobs, resources, services, and utilities. In contrast, economic growth expresses a nation’s development in terms of capital and monetary figures.
  • Economic stability is a nation’s ability to withstand crisis and downturn. In contrast, economic growth only outlines income, revenue, and profit increase.
  • Economic stability draws a clearer picture of a nation’s ground reality; it exposes issues like income inequality and unemployment. In contrast, economic growth is easier to quantify; it can be expressed in absolutes.

Financial Stability vs Monetary Stability

  • Financial stability refers to the overall stability of a country’s financial system. In contrast, monetary stability refers to price stability. Price stability occurs when there is an absence of large swings in the general level of prices in the economy.
  • Economic stability is a long-term process; central banks play a significant role by controlling inflation and the money supply. In contrast, price stability is achieved by avoiding lengthy phases of excessive inflation or deflation. As a result, monetary stability ensures high employment levels and moderate long-term interests.
  • The economic stability of a country impacts the world economy. Similarly, monetary stability affects the economic stability of a nation.
  • When a government fails to achieve economic stability, the country experiences a financial crisis. Similarly, when a government fails to maintain monetary stability, the country experiences inflation.

Frequently Asked Questions (FAQs)

1. What is a financial stability board?

FSB is an international authority that monitors global markets. Based on pressing needs, the FSB suggests amendments. The board was established in 2009 to promote global economic stability. FSB works in coordination with regulatory bodies and central banks. It enables stability in financial markets and imposes jurisdiction when needed.

2. How to measure financial stability?

Metrics like GDP, inflation, fiscal deficit, trade deficit, interest rates, employment levels, and income inequality are used to gauge the economic stability of a nation.

3. What is the purpose of financial stability?

Governments try to maintain economic stability for the following reasons:
– For the smooth functioning of banks and financial institutions.
– For the efficient allocation of services and resources.
– To initiate long-term growth.

This article has been a guide to Financial Stability and its meaning. Here, we explain its importance, examples, measures, and comparison with monetary stability. You can learn more about it from the following articles –

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