In this post I would like to quote some theories and real time cases at a very basic level to mock the relation between Price Stability (PS) and Financial Stability (FS). There is a very sensitive and interesting relationship between them. The thin line between the two makes them go hand in hand and also hamper each other.
To start with Schwartz Hypothesis .It says that sustained inflation encourages speculative investment and borrowing because there exists an expectation that prices will continue to rise. When inflation abruptly declines borrower incomes may prove insufficient to repay loans that had been made with the expectation of continued price increases. The resulting rise in borrower defaults reduces the equity of lenders, possibly causing an increase in financial institution failures. In the absence of inflation and disinflation, real shocks, such as those affecting commodity markets in the 1970s and early 1980s, might still cause significant financial distress. The Schwartz Hypothesis argues, however, that if the aggregate price level is stable, or at least if its movements are fully predictable, then resources will be employed more economically, and financial distress, regardless of its proximate cause, will be less severe.
That means with this hypothesis it is clear that
Price Stability α Financial Stability
Hence more stable (Stable doesn’t mean static It mean a slow pace increase) the prices, more predictable economy and encourages better investment which leads to financial stability.
As we know price stability depends upon the “monetary policy” of the economy which is in the hands of the respective central bank.
The years before the crisis saw a powerful intellectual consensus building around inflation targeting. A growing number of central banks, starting with New Zealand in the late 1980s and currently numbering over 20, geared monetary policy almost exclusively to stabilizing inflation. Even where central banks did not target a precise inflation rate, their policy objectives were informed, if not dominated, by price stability. This approach seemed successful. There was an extended period of price stability accompanied by stable growth and low unemployment. In the world that existed before the crisis, central bankers were a triumphant lot. They had discovered the Holy Grail.
The unravelling of the Great Moderation during the crisis has diluted, if not dissolved, the consensus around the minimalist formula of inflation targeting. The mainstream view before the crisis was that price stability and financial stability reinforce each other. The crisis has proved that wrong. We have seen that price stability does not necessarily ensure financial stability. Indeed there is an even stronger assertion - that there is a trade-off between price stability and financial stability and that the more successful a central bank is with price stability, the more likely it is to imperil financial stability.
So here,
Price Stability α 1/(financial Stability)
All in all, the crisis has given fresh impetus to the ‘new environment hypothesis’ that pure inflation targeting is inadvisable and that the mandate of central banks should extend beyond just price stability.
Hence the Million or the Billion or even more costlier question here is
“Should central banks persist with pure inflation targeting? “
Diplomatic answers like
1) There should be a trade off between restriction and development
2) Should be dealt by case to case
can easily be given.
But I personally think both the answers keep us grope in the darkness to find the thin line between the PS and FS. A clear framework is required to thicken the line.
And the stage is now left to the policy makers and economists to come out with the right extinguisher to address this burning problem. I am ending my article with a question, because it is yet unanswered.
