The notion that central banks should act as lenders of last resort is not controversial. How best to carry out that responsibility is, however, not widely agreed upon. One view holds that the financial system is inherently fragile, and a central bank should forego other objectives, such as preventing inflation, when financial instability threatens. An alternative view argues that by controlling inflation a central bank will in fact promote financial stability. Anna Schwartz (1988; 1995), for example, contends that financial instability has often been caused by monetary policies that cause fluctuations in the rate of inflation. She argues that monetary policy should focus exclusively on maintaining price stability.
A few countries, e.g., Canada and New Zealand, have recently made inflation control the paramount objective of their central bank's monetary policy, and the Maastricht Treaty, which established monetary union among eleven European Community countries, specifies control of inflation as the principal objective for the European Central Bank. Most countries, however, including the United States, assign their central banks multiple objectives, such as full employment and financial stability, as well as inflation control. Implicitly, the specification of multiple objectives for monetary policy assumes tradeoffs between those goals that a country might have to accept higher inflation, at least temporarily, to maintain financial stability, for example.
This paper investigates the historical association between aggregate price and financial stability to shed light on the question of whether a commitment to price stability is likely to enhance or lessen financial stability. Specifically, we use data for the United States from 1790 to 1997 to test the hypothesis that aggregate price disturbances cause or worsen financial instability. Unanticipated aggregate price declines might increase financial distress by leaving some borrowers with insufficient income to repay contracted nominal debt.
Thus unanticipated aggregate price declines would increase insolvency and default rates. Positive aggregate price shocks, on the other hand, might cause default rates to fall below expectations, and could encourage financial expansion if borrowers and lenders are unable to distinguish changes in relative prices from changes in the aggregate price level. Financial expansion based on aggregate price misperceptions can lead to resource misallocation, however, and thereby worsen financial distress associated with subsequent unanticipated aggregate price declines.
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Aggregate Price Shocks and Financial Instability: A Historical Analysis
