Working Paper: NBER ID: w7652
Authors: Michael D. Bordo; Michael J. Dueker; David C. Wheelock
Abstract: This paper presents empirical evidence on the hypothesis that aggregate price disturbances cause or worsen financial instability. We construct two annual indexes of financial conditions for the United States covering 1790-1997, and estimate the effect of aggregate price shocks on each 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 shocks needed to substantially alter financial conditions depends on the institutional environment, but that a monetary policy focused on price stability would be conducive to financial stability.
Keywords: aggregate price shocks; financial instability; historical analysis; monetary policy
JEL Codes: E31; E52; C25; N10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| aggregate price shocks (E30) | financial instability (F65) |
| unanticipated aggregate price declines (E30) | financial distress (G33) |
| unanticipated aggregate price declines (E30) | insolvency (G33) |
| unanticipated aggregate price declines (E30) | default rates (E43) |
| positive aggregate price shocks (E31) | default rates (E43) |
| positive aggregate price shocks (E31) | financial expansion (F30) |
| financial expansion (F30) | misallocation of resources (D61) |
| aggregate price instability (E30) | financial instability (F65) |
| institutional environment (D02) | severity of financial instability (F65) |