Is monetary policy safeguarding financial stability in India?

• Published date: 01 May 2021
• Author: Vimarsh Padha,Pabitra K. Jena,Bikash R. Mishra,Mantu K. Mahalik
• Date: 01 May 2021
• DOI: http://doi.org/10.1002/pa.2196

ACADEMIC PAPER

Is monetary policy safeguarding financial stability in India?

Vimarsh Padha

1

| Pabitra K. Jena

1

| Bikash R. Mishra

2

| Mantu K. Mahalik

3

1

School of Economics, Faculty of

Management, Shri Mata Vaishno Devi

University, Katra, Union Territory of Jammu &

Kashmir, India

2

Department of Humanities and Social

Sciences, National Institute of Technology,

Rourkela, India

3

Department of Humanities and Social

Sciences, Indian Institute of Technology,

Kharagpur, India

Correspondence

Pabitra K. Jena, School of Economics, Faculty

of Management, Shri Mata Vaishno Devi

University, Katra, Union Territory of Jammu &

Kashmir, India

Email: pabitrakumarjena@gmail.com

Over the years, there has been an increasing debate over the role of the Central Bank

in targeting the policy objectives and the extent to which the targets can anchor the

expectations. The present study seeks to identify the linkage between monetary pol-

icy and financial stability in India. The study, based on quarterly data from January

2001 to July 2018, finds that the financial sector allied variables (BSE SENSEX index,

Exchange Rate and Index of Industrial Production) have shown significant response

to shocks in the policy rate, that is, reverse repo rate, except for exchange rate vari-

able that was taken as a proxy for external sector stability. Also in the short-run,

when a shock is imparted to the policy rate, the response of the exchange rate is

insignificant. Other than that, the corporate sector along with real output growth and

banking sector variables induces a significant change in policy rate when a shock is

introduced. With variables responding in the ideal direction to shock in the policy

rate, it is inferred that the movement is in line with what ideally should hold over

time. This leads us to conclude that the monetary policy safeguards financial stability

in India.

JEL CLASSIFICATION

E02; E52; G280 & E310

1|INTRODUCTION

Reinvestigating the causes of financial instability has probably been

one of the most notable debates in the discipline of macroeconomics

after the 2007–2008 financial crisis. One of the most recent debates

currently centers on investigating whether the Central Bank and other

policy practitioners should bring stability in financial markets and

financial institutions. One set of economists argues that the Central

Bank should not be concerned with such matters while others view

that it is a reasonable concern. With increased access to financial mar-

kets, agents in the economy are more susceptible to financial market

shocks.

This makes the overall economy more sensitive to financial mar-

ket shocks, especially from the systemically important institutions.

When it comes to defining financial stability, generally, the definition

has accommodated a particular theme of a paper or speech. Given the

multifaceted nature, the definitions and measures vary (Borio &

Drehmann, 2009). While Mishkin (1999) outlines financial stability as

“when shocks to financial system hamper information flow so that it is

unable to channelize funds for enabling productive investment

opportunities,”Crockett (1997) also defines financial stability as the

state of fluctuations in the price of financial assets, upsetting eco-

nomic performance. In layman terms, it can be thought of as a sce-

nario where the financial sector can smoothly perform intermediation.

Schinasi (2005) defines financial stability as “the ability of the financial

system to facilitate and enhance economic processes, manage risks,

and absorb shocks.”

The importance of financial stability, especially in the long-run, is

inextricably linked with monetary stability. The Great Depression in

the 1930s and the Japanese economy experiences from the 1990s till

the beginning of the twenty-first century further reflect the conse-

quence of financial instability ending up in a deflationary spiral; the

key functions like supervision and the lender of last resort have finan-

cial stability characteristics rooted in them. Contrasting the body of

research on price stability and unemployment, the theoretical sub-

structures of financial stability practices remained comparatively

evolving and quite fragmented. Fundamental theories on the macro-

economic front that relate to financial stability centered around the

hypothesis inferring the existence of feedback between financial

activities and real economic activities, cited that moderation might be

Received: 22 March 2020 Accepted: 20 May 2020

DOI: 10.1002/pa.2196

J Public Affairs. 2021;21:e2196. wileyonlinelibrary.com/journal/pa © 2020 John Wiley & Sons, Ltd 1of11

https://doi.org/10.1002/pa.2196