Journal of Stock & Forex Trading
Open Access

Significance of Financial Stability in Economy

Robert Heinlein^{* *}Correspondence: Robert Heinlein, Department of Finance, Rutgers University, New Jersey, USA, Email:

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Description

Financial stability is a characteristic of a financial system that reduces financial imbalances brought on by substantial unfavorable events or endogenous financial market fluctuations. When the system is stable, it largely uses self-correcting processes to absorb economic shocks, preventing the negative occurrences from destabilizing the real economy or affecting other financial systems. Financial stability is crucial for economic growth since the financial sector supports the majority of transactions in the real economy. Historically, the Reserve Bank has been in charge of preserving the stability of the financial system. An efficient exchange of money between savers and investors is made possible by stable financial institutions, markets, and market infrastructures. This supports the expansion of economic activities.

The definition of financial stability is "a state in which the financial system is not unstable." Additionally, it can refer to a state of stability for the three elements of the financial system — financial institutions, financial markets, and financial infrastructure. The term "financial institution stability" describes a situation in which each financial institution is strong enough to perform its financial intermediation role effectively, without aid from outside institutions, such as the government. Financial market stability refers to a state in which there is little to no significant interruption of market activity and little to no considerable divergence between the values of financial assets and economic fundamentals, allowing for the confident raising and use of capital by economic agents.

The phrase "situation in which the financial system can assist real economic operations smoothly and is capable of unraveling financial imbalances emerging from shocks" is a more general definition of financial stability. A stable financial system must be able to effectively allocate resources, assess and manage financial risks, and maintain employment levels close to the natural rate of the economy in order to maintain employment levels that are close to that rate and to prevent relative price movements of real or financial assets that could threaten monetary stability or employment levels. When financial imbalances that occur endogenously or as a result of substantial unfavorable events are eliminated, a financial system is considered to be stable. When the system is stable, it will mostly absorb shocks through selfcorrective mechanisms, preventing bad events from disrupting the real economy or other financial systems. Given that the financial sector facilitates the majority of transactions in the actual economy, financial stability is essential for economic growth.

Importance

In the economy, the financial system is crucial. It enables the financial intermediation process, which facilitates the transfer of funds from savers to borrowers and guarantees that funds are utilized efficiently to support economic growth and development. Due to its contagion or spillover effects to other sectors of the economy, financial instability and its impacts on the economy can be exceedingly expensive. Indeed, it could trigger a financial catastrophe that would be bad for the economy. Therefore, it is essential to have a strong, stable, and healthy financial system to support the effective distribution of resources and risks throughout the economy.

In order for the economy to grow and maintain price stability, which is the central bank's policy objective, there must be financial stability. This is due to the fact that financial instability has a significant negative impact on an economy since it makes pricing factors in the financial markets more volatile and raises the risk of financial institutions or businesses failing. Additionally, because economic agents struggle to make logical judgments and resource allocation is less efficient, economic development may be constrained during this time. According to the Bank, the term "financial system stability" refers to the effort made by the institution to encourage the growth of reliable and well-run banks and other financial institutions as well as effective and functional financial markets.