Research Discussion Paper – RDP 2021-03 Financial Conditions and Downside Risk to Economic Activity in Australia

We apply the growth-at-risk framework to the Australian economy. This allows us to estimate how important current financial conditions are in explaining future downside risk to key macroeconomic variables. As such, it provides a way to quantify the economic costs of financial instability. In order to implement this framework, we develop a new financial conditions index for Australia and show that it correlates closely with previous episodes of financial instability. We find that more restrictive financial conditions play an important role in explaining downside risk to growth in both GDP and employment and upside risk to changes in the unemployment rate. Our measure of financial conditions is, however, less useful for explaining risks to growth in household consumption and business investment. Overall, the framework provides a useful characterisation of the relationship between financial stability and economic activity in Australia.