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This chapter examines the relation between monetary and financial stability, looking at possible chains of cause and effect running in both directions between them—from the possibility that an unexpected tightening of monetary policy increases the mean probability of financial system distress, to the general risk of monetary stability being undermined by financial instability. The idea that monetary stability encourages financial instability is controversial. Inflation is often the root cause of financial instability by distorting information flows between lenders and borrowers, leading to asset bubbles and over investment. Most empirical evidence tends to support the view that monetary stability should promote financial stability in the long run and not the other way around. But while monetary stability is a necessary condition for financial stability, it is not a sufficient one. In other words, financial instability can still occur even with the inflation rate under control.
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