Reserve Bank of India Occasional Papers Vol. 32, No. 3, Winter 2011 Financial Stability, Economic Growth, Inflation and Monetary Policy Linkages in India: An Empirical Refection Sarat Dhal, Purnendu Kumar and Jugnu Ansari * Economic growth and infation are often used to characterize economic stability and monetary or price stability. This study provides an empirical assessment of crucial issues relating to the linkages of fnancial stability with economic growth and infation in the Indian context. For this purpose, the study uses vector auto-regression (VAR) model comprising output, infation, interest rates and a banking sector stability index. The banking stability index is constructed with capital adequacy, asset quality, management effciency, earnings and liquidity (CAMEL) indicators. Our empirical investigation reveals that fnancial stability on the one hand and macroeconomic indicators comprising output, infation and interest rates on the other hand can share a statistically signifcant bi-directional Granger block causal relationship. The impulse response function of the VAR model provides some interesting perspectives. First, fnancial stability, growth and infation could share a medium-longer-term relationship. Second, enhanced fnancial stability could be associated with higher growth accompanied by softer interest rates and without much threat to price stability in the medium to long term. Third, greater economic stability or higher output growth can enhance fnancial stability. Fourth, higher infation or price instability could adversely affect fnancial stability. Fifth, fnancial stability can contribute to the effectiveness of monetary transmission mechanisms. Finally, with fnancial stability, output growth could become more persistent and infation less persistent. JEL : E02, E52, G280, E310, O430, C320 Key words : Institutions and macroeconomy, fnancial stability, monetary transmission, price stability, economic stability, fnancial regulation Introduction Should fnancial stability be pursued as a goal of policy? Can fnancial stability goal be pursued along with conventional objectives of policy such as economic stability and monetary stability, which are often postulated in terms of economic growth and aggregate price infation, * Sarat Dhal and Jugnu Ansari are Assistant Advisers in the Department of Economic and Policy Research and Department of Statistics and Information Management, respectively and currently working at the Centre for Advanced Financial Research and Learning, Reserve Bank of India, Mumbai. Purnendu Kumar is Assistant Adviser in the Department of Statistics and Information Management, Reserve Bank of India, Mumbai. The responsibility for the views expressed in the paper lies with the authors only and not the organisation to which they belong. The authors are grateful to the anonymous referee for insightful comments.