DSGE models combining microeconomic and asset price data with macroeconomic variables, such as investment and consumption, further confirm the critical role of imperfections. Gilchrist et al (2009) demonstrate the quantitative importance of imperfections by examining credit spreads on the senior unsecured debt issued by a large panel of nonfinancial firms. Estimating a DSGE model that links balance sheet conditions to the real economy through movements in the external finance premium (using credit spreads as proxy), they show that rising external finance premia are related to subsequent declines in investment and output. They also show that credit market shocks contributed significantly to US economic fluctuations during 1990–2008. In related studies, Gerali et al (2010) and AttaMensah and Dib (2008) incorporate credit risk into standard DSGE models and quantify the role of frictions in business cycle fluctuations.

Studies using DSGE models have also shown how endogenous developments in housing markets can magnify and transmit shocks. Aoki et al (2004) quantify the effects of shocks to housing investment, housing prices and consumption in a model in which houses serve as collateral to reduce borrowing-related agency costs. Campbell and Hercowitz (2009) investigate the impact of mortgage market deregulation in a calibrated general equilibrium framework with borrowing-constrained households. Iacoviello (2005) constructs a model in which households’ collateral constraints are connected to real estate, and finds that collateral and accelerator effects are critical in replicating the changes in consumption resulting from movements in house prices.<sup>18</sup> Aspachs-Bracons and Rabanal (2010) report that, while labour market frictions are critical in accounting for the main features of housing cycles in Spain, financial frictions associated with collateral constraints appear less important.

Using a framework in which house prices and business investment are linked, recent studies show how credit constraints affect macroeconomic fluctuations. For example, Liu et al (2013) study the close relationship between land prices and business investment. They focus on land prices because most of the fluctuations in house prices are driven by land prices rather than by the cost of construction (Davis and Heathcote (2007)). They introduce land as a collateral asset in firms’ credit constraints and identify a shock that drives most of the observed fluctuations in land prices. Since firms are credit-constrained by land value, a shock to housing demand originating in the household sector triggers competing demands for land between the household and business sectors. This sets off a financial spiral that drives large fluctuations in land prices and strong comovements between land prices and investment, consumption and hours worked.

Some other studies, using DSGE models, analyse the importance of disturbances in housing markets in explaining certain features of business cycles. Monacelli (2009) shows that a borrowing constraint, where durables play the role of collateral asset, improves on a standard New Keynesian model’s ability to match the positive comovement of durable and non-durable spending and the large response of durable spending to shocks. Davis and Heathcote (2005) show how a multi-sector growth model – with housing affecting household borrowing and spending – matches many empirical facts: consumption, residential investment

> 18 Guerrieri and Iacoviello (2013) present a model with collateral constraints that displays asymmetric responses to house price changes. In their model, collateral constraints become muted when housing wealth is high (shocks to house prices lead to small and positive changes in consumption and hours worked). However, collateral constraints become tight when housing wealth is low (shocks to house prices translate into negative and large changes in consumption and hours worked). Kannan et al (2012) consider the importance of credit constraints in driving the linkages between house prices and macroeconomic fluctuations.  Iacoviello and Pavan (2013) and Iacoviello (2004, 2015) also consider the role of housing markets in explaining business cycles. Wachter et al (2014) present a collection of papers on the role of housing markets during the GFC.

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