Housing Market Heterogeneity in a Monetary Union Margarita Rubio

This paper studies the implications of cross-country housing market heterogeneity for a monetary union. I develop a two-country new Keynesian general equilibrium model with housing and collateral constraints to explore this issue. Results show that consumption reacts more strongly to common shocks in countries with high loan-to-value ratios (LTVs), a high proportion of borrowers or variablerate mortgages. As for asymmetric technology shocks, output and house prices increase by more in the country receiving the shock if it can conduct monetary policy independently. I also nd that after country-speci c housing price shocks consumption does not only increase in the country where the shock takes place, there is an international transmission. From a normative perspective, I conclude that housing-market homogenization in a monetary union is not bene cial per se, only when it is towards low LTVs or predominantly xed-rate mortgages. Furthermore, when there are asymmetric shocks, bene ts from forming a monetary union with respect to having a exible exchange rate regime decrease signi cantly if there is housing market heterogeneity. Keywords: Housing market, collateral constraint, monetary policy, monetary union JEL Codes: E32, E42, E44 Bank of Spain, Alcalá 48, 28014, Madrid, Spain. margarita.rubio@bde.es. I am truly thankful to Fabio Ghironi, Matteo Iacoviello and Peter Ireland for their invaluable advice. A great part of this project has been undertaken during my stays at the Federal Reserve Board and at the Bundesbank. I thank them for their nancial support and helpful comments. All errors are mine. 1 "Several of the bene ts of the euro are already clearly visible, such as the deepening of trade and nancial links between euro area countries and the greater resilience of the euro area to external shocks. Today I will discuss both of these accomplishments, and I will also touch on some of the challenges that we continue to face. For instance, there is presently a degree of diversity among euro area countries". Jean-Claude Trichet, October 8, 2007. 1 Introduction Costs and bene ts of monetary unions are a much discussed topic, especially in relation to the Europes Economic and Monetary Union (EMU). There are clear arguments in favor. A single currency eliminates exchange rate risk, allows rapid price comparison and lowers transaction costs across countries. However, costs can arise if countries are not su¢ ciently similar. Di¤erent national characteristics such as heterogeneous institutions, consumption patterns or nancial structures can be a source of di¤erent transmission of common shocks in a monetary union. Also, country-speci c shocks derived from member heterogeneity can enhance the possible divergence. In this paper, I focus on housing markets. I consider how heterogeneous housing markets across members a¤ect the transmission of shocks (both symmetric and asymmetric) in a currency area. I also use welfare analysis to evaluate whether housing market homogenization is bene cial in a monetary union and whether countries with asymmetric shocks should join in a monetary union, especially when they have di¤erent housing characteristics. Countries in Europe clearly di¤er in their housing markets. There is evidence of di¤erent loanto-value ratios (LTVs), di¤erent proportion of residential debt relative to GDP across countries and heterogeneous mortgage contracts. Also, house price movements do not show the same pattern in every country. Maclennan et al (1998) point out the importance of such heterogeneity in a monetary union. They conclude that there should be an e¤ort toward institutional homogenization among European countries to alleviate possible tensions. LTVs in Europe range from 16% in France1 to 73% in Germany or 95% in Sweden. European countries also di¤er in their proportion of borrowers. The residential debt to GDP ratio ranges from values such as 18.7% in Italy to 98.4% in the Netherlands or 100.8% in Denmark. In those countries with a high LTV or a high proportion of indebted consumers, housing collateral e¤ects are stronger. Therefore, shocks According to the European Mortgage Federation, the average loan-to-value ratio for rst-time buyers reached a low 16% in 2004 due to house price ination and low interest rates.