House Prices , Borrowing Constraints and Monetary Policy in the Business Cycle

I develop and estimate a monetary business cycle model with nominal loans and collateral constraints tied to housing values. Demand shocks move together housing and nominal prices, and are amplified and propagated over time. The financial accelerator is not uniform: nominal debt dampens supply shocks, stabilizing the economy under interest rate control. Structural estimation supports two key model features: collateral effects dramatically improve the response of aggregate demand to house prices shocks; nominal debt improves the sluggish response of output to inflation surprises. Finally, policy evaluation considers the role of house prices and debt indexation in affecting monetary policy trade-offs. (JEL E31, E32, E44, E52, R21) ∗Department of Economics, Boston College, Chestnut Hill, MA 02467, USA (email: iacoviel@bc.edu). I am deeply indebted to my Ph.D. advisor at the London School of Economics, Nobuhiro Kiyotaki, for his continuous help and invaluable advice. I thank Fabio Canova, Raffaella Giacomini, Christopher House, Peter Ireland, Raoul Minetti, François Ortalo-Magné, Marina Pavan, Christopher Pissarides, Fabio Schiantarelli, two anonymous referees and seminar participants at the Bank of England, Boston College, the European Central Bank, the Ente Luigi Einaudi, the Federal Reserve Bank of New York, the Federal Reserve Bank of St.Louis, the London School of Economics, the NBER Monetary Economics Meeting and Northeastern University for their helpful comments on various versions of this work. Viktors Stebunovs provided superb research assistance. “The population is not distributed between debtors and creditors randomly. Debtors have borrowed for good reasons, most of which indicate a high marginal propensity to spend from wealth or from current income or from any other liquid resources they can command. Typically their indebtedness is rationed by lenders [...]. Business borrowers typically have a strong propensity to hold physical capital [...]. Their desired portfolios contain more capital than their net worth [...]. Household debtors are frequently young families acquiring homes and furnishings before they earn incomes to pay for them outright; given the difficulty of borrowing against future wages, they are liquidity-constrained and have a high marginal propensity to consume” James Tobin (1980), Asset Accumulation and Economic Activity : Reflections on Contemporary Macroeconomic Theory A long tradition in economics, starting with Irving Fisher’s (1933) debt-deflation explanation of the Great Depression, considers financial factors as key elements of business cycles. In this view, deteriorating credit market conditions, like growing debt burdens and falling asset prices, are not just passive reflections of a declining economy, but are themselves a major factor depressing economic activity. Although this “credit view” has a long history, most of theoretical work on this subject has been partial equilibrium in nature until the late 1980s, when Ben Bernanke and Mark Gertler (1989) formalized these ideas in a general equilibrium framework. Following their work, various authors have presented dynamic models in which financing frictions on the firm side may amplify or propagate output fluctuations in response to aggregate disturbances: examples include the real models of Nobuhiro Kiyotaki and John Moore (1997) and Charles Carlstrom and Timothy Fuerst (1997), and the sticky-price model of Bernanke, Gertler and Simon Gilchrist (1999). Empirically, various studies have shown that firms’ investment decisions are sensitive to various measures of firms’ net worth (see Glenn Hubbard, 1998, for a review). At the same time, evidence of financing constraints at the household level has been widely documented by Stephen Zeldes (1989), Tullio Jappelli and Marco Pagano (1989), John Campbell and Gregory Mankiw