Asset prices, financial and monetary stability: exploring the nexus

The last twenty years of the 20th century are simultaneously characterised by a positive phase for the monetary economy thanks to the maintaining of price stability and a troublesome phase for the financial economy.

This paper addresses whether:

• this situation is coincidental
• there is any relationship between monetary and financial stability
• it is possible to guarantee both at the same time
• there are specific conditions under which unsustainable booms in economic activity show up as financial imbalances rather than as inflationary pressures

The main findings of this study are:

• financial imbalances are particularly likely when there is disinflation or inflation is really low
• cooperation between prudential and monetary authorities is essential to response to these imbalances
• sustained rapid credit growth combined with large increases in asset prices appears to increase the probability of an episode of financial instability
• although low inflation ensures financial stability, it is also true that it can lead to excess demand pressures revealing first in credit aggregates and asset prices, rather than in goods and services prices

Finally, the paper recommends that:

• more and better empirical research is made to analyse the conditions that increase the likelihood of financial strains
• more and better analytical research is made to understand how financial fluctuations depend on the interaction between financial and real factors