Aggregate price shocks and financial instability: A historical analysis

Abstract

This article presents evidence on the relationship between price and financial stability. We construct an annual index of financial conditions for the United States, 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. The size of the aggregate price shock needed to alter financial conditions depends on the institutional environment, but we conclude that a monetary policy focused on price stability would contribute to financial stability.