Monetary Policy–Financial Stability Nexus: An Empirical Analysis of India

Given the intricacies between monetary policy and financial stability, it is imperative for central banks to identify financial stability risks. The study constructs an index of financial stability in India using a Principal Component Analysis (PCA)-based approach by considering 15 variables across 4 financial market segments for the period 2000–2021. The study then uses this index with the policy rate and the monetary policy objective, inflation, along with output growth, in a Structural Vector Autoregression (SVAR) setting to analyse the cross-impacts of shocks in these variables. The results highlight that changes in the policy rate and inflation are significantly influenced by financial stability, both responding with a lag of around one quarter. Similarly, the results also support the dependence of financial stability situation on the policy rate and inflation, providing justification for considering financial stability in monetary policy decisions. JEL Codes: E52, E53, E51, G10