Financial Stability and Financial Distortions: A Saddle Path Equilibrium between the Crowding Out Effect and the Financial Accelerator

Various methods of modeling based on stress testing and macrofinancial modeling have been adopted in the literature on financial stability assessment and all display merits as well as drawbacks. The literature on the subject matter of financial stability assessment is still in its infancy and requires novelties with respect to methodologies adopted in the assessment process. The eviction effect or the crowding out effect and the financial accelerator are two issues that are compromisingly involving for financial stability, economic policy making and the nexus between the macroeconomic imperfections and financial imbalances. As far as interactions between key determinants of financial stability are concerned, there is a longstanding dissensus on the impact of the crowding out effect on financial stability as it is an issue intertwined compromising public policy and financial matters whereby the crowding out effect is found to be acting like an actor partially offsetting and slowing down the negative effects of the financial accelerator on financial stability in what we call a saddle path unstable equilibrium following the tendency of the trend of the effect of the financial accelerator on financial stability temporarily then abruptly turning the tendency of the effect of the financial accelerator on financial stability sequentially to mitigate instability partially. This raises concerns about a novel method to assess financial stability and the likely merits of modeling financial stability taking into consideration these two items of commensurate relevance and importance to highlight two main economic effects namely the double dividend theory in presence of distortions and the close relationship of economic and financial matters in face of the hindrance of providing a clear insight into interactions and cross effects among determinants of financial stability. The main scope of going deeper into the intertwined relationship between the eviction effect and the financial accelerator is to better fathom financial stability while at the same time waiving the drawbacks of conventional methods of financial stability assessment that always impair features of commensurate relevance to herald specific concern about microfinancial considerations or macrofinancial considerations and in some instances prioritizing rare innovations or contrariwise neglecting them roughly. The proposed saddle path equilibrium modeling shows clearly the cross effects and interactions of relevant features composing financial stability assessment while at the same time including key microeconomic features relevant to systemic risk in a comprehensive way. The approach highlights indeed the role played by equity and credit in affecting financial stability. It provides impetus on the effect of government bonds and securities between the credit market and the stock market sectors that makes improvement in stock market sector trading of government securities or attract ability to banking placement or incur draining loanable funds through increase in stock market profitability and deteriorates credit market financial stability by the demand pull effect through the effect of liquidity risk on credit risk in the face of limited tolerance to overall risk incurred by banks and the search for yield motivation of banks. The effect on financial stability through the Stock market sector or what we call the saddle path unstable equilibrium between crowding out effect and the financial accelerator constitutes the cornerstone of our research and will be thoroughly analyzed and scrutinized throughout the mathematical proofs provided in the research referring to the polynomial distributions of risk, the gaussian pivot for multivariate discrete functions, the saddle path unstable equilibrium and the reference to sensitivity analyses and constitutes the novelty provided by this research in face of the drawbacks of available measurement methods displayed in the literature of relevance for the subject matter.