In the recent past, research in developed markets has aimed at developing various indices that can be applied to apprehend the impact that financial stress can have on a country’s economic activity. This article reviews the literature on financial stress and its impact on economic activities. It further presents a proposed methodology for constructing financial stress index and its implications for macroeconomic performance in relation to Pakistan. A review of the literature was conducted discussing (a) the formulation of the financial stress index and (b) its impact on the country’s economic activity indicators. The analysis of the literature made it possible to identify the current themes and remaining gaps in the literature on the financial stress index. It is concluded that FSI is beneficial for monitoring and evaluating the usefulness of government economic policies in crisis as well as normal times. Moreover, the index grabs the stresses in the form of financial stress, which is not only from various market sectors but also from their connection through a contagious effect internationally. Therefore, the paper concludes that the FSI could be established and used as an effective tool to measure and monitor financial stress level and its impact on various economic activity indicators in Pakistan.
Keywords: Financial Stress Index, GDP, Industrial Production, Foreign Trade, PCA, Emerging Markets, Pakistan.