Economic stability

Economic stability refers to an absence of excessive fluctuations in the macroeconomy. An economy with fairly constant output growth and low and stable inflation would be considered economically stable. An economy with frequent large recessions, a pronounced business cycle, very high or variable inflation, or frequent financial crises would be considered economically unstable.

A financial system is stable when it dissipates financial imbalances that arise endogenously or as a result of significant adverse and unforeseeable events. When stable, the system absorbs shocks primarily via self-corrective mechanisms, preventing the adverse events from disrupting the real economy or spread over to other financial systems. Financial stability is paramount for economic growth, as most transactions in the real economy are made through the financial system.

Without financial stability, banks are more reluctant to finance profitable projects, asset prices may deviate significantly from their intrinsic values, and the payment settlement schedule diverges from the norm. Hence, financial stability is essential for maintaining confidence in the economy. Possible consequence of excessive instability includes: bank runs, hyperinflation, or .

The Altman’s z‐score is extensively used in empirical research as a level of firm-level stability for its high correlation with the probability of default. This measure contrasts buffers (capitalization and returns) with risk (volatility of returns), and proven to be accurate at predicting bankruptcies within two years. Despite development of alternative models to predict financial stability Altman’s model remains the most widely used.

An alternate model used to measure institution-level stability is the Merton model (also called the asset value model). It evaluates firm’s ability to meet its financial obligations and gauges the overall possibility of default. In this model, an institution’s equity is treated as a call option on its held assets, taking into account the volatility of those assets. Put-call parity is used to price the value of the implied “put” option, which represents the firm's credit risk. Ultimately, the model measures the value of the firm’s assets (weighted for volatility) at the time that the debtholders exercises their “put option” by expecting repayment. Implicitly, the model defines default as when the value of a firm’s liabilities exceeds that of its assets calculate the probability of credit default. In different iterations of the model, the asset/liability level could be set at different threshold levels.

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