Aggregate Price Shocks and Financial Instability: A Historical Analysis
This paper presents historical evidence on the relationship between aggregate price and financial stability. We construct an annual index of financial conditions for the United States covering 1790-1997, and estimate the effect of aggregate price shocks on the index using a dynamic ordered probit model. We find that price level shocks contributed to financial instability during 1790-1933, and that inflation rate shocks contributed to financial instability during 1980-97. Our research indicates that the size of the aggregate price shock needed to alter financial conditions substantially depends on the institutional environment, but that a monetary policy focused on price stability would be conducive to financial stability.