Monitoring Financial Conditions and Downside Risk to Economic Activity in Australia*

Abstract

We develop a new financial conditions index for Australia and use it to apply the growth‐at‐risk framework to the Australian economy. The index correlates closely with previous episodes of financial instability and 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. We find that more restrictive financial conditions play an important role in explaining downside risk to growth in both gross domestic product 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.