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Journal of Economic Dynamics & Control 37 (2013) 28622881

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Journal of Economic Dynamics & Control


journal homepage: www.elsevier.com/locate/jedc

Monetary policy transmission in a model with


animal spirits and house price booms and busts
Peter Bofinger, Sebastian Debes, Johannes Gareis, Eric Mayer n
University of Wrzburg, Department of Economics, Sanderring 2, 97070 Wrzburg, Germany

a r t i c l e in f o

abstract

Article history:
Received 7 November 2011
Received in revised form
1 August 2013
Accepted 5 August 2013
Available online 14 August 2013

Can monetary policy trigger pronounced boom-bust cycles in house prices and create
persistent business cycles? We address this question by building heuristics into an otherwise
standard DSGE model. As a result, monetary policy sets off waves of optimism and pessimism
(animal spirits) that drive house prices, that, in turn, have strong repercussions on the
business cycle. We compare our findings to a standard model with rational expectations by
means of impulse responses. We suggest that a standard Taylor rule is not well-suited to
maintain macroeconomic stability. Instead, an augmented rule that incorporates house prices is
shown to be superior.
& 2013 Elsevier B.V. All rights reserved.

JEL classification:
E32
E52
D83
Keywords:
Monetary policy
Animal spirits
Housing markets

1. Introduction
The recent boom-bust cycle in the U.S. housing market and its repercussions on financial and economic developments
have ignited a debate about the driving forces of the recent housing cycle and on the role of housing in the monetary policy
transmission mechanism in general.1 In this paper, we take up these issues and incorporate heuristics into an otherwise
standard dynamic stochastic general equilibrium (DSGE) model that captures important features of housing and provide
qualitative insights into how monetary policy actions affect the housing market and in turn the overall economy when
behavioral mechanisms play a role. The reasons to do so are twofold. First, for many people behavioral mechanisms provide
a natural way to explain the emergence of the recent U.S. house price cycle. For instance, Shiller (2007) states that the recent
U.S. house price rally represented notions of a speculative bubble. Also Kohn (2007) emphasizes that when studies are done
with cooler reflection, the causes of the swing in house prices will be seen as less a consequence of monetary policy and more a
result of emotions of excessive optimism followed by fear. Second, from a modeling perspective, the notion of heuristics
is substantial because the vast majority of recent DSGE models that deal with the role of the housing market in the
macroeconomy rely on the rational representative agent approach (see Iacoviello, 2005; Paris and Notarpietro, 2008;
Iacoviello and Neri, 2010; Aspachs-Bracons and Rabanal, 2010, 2011; Forlati and Lambertini, 2011; Calza et al., forthcoming,

Corresponding author. Tel.: +49 931 3182948; fax: +49 931 3187275.
E-mail address: eric.mayer@uni-wuerzburg.de (E. Mayer).
1
See the Jackson Hole Conference organized by the Federal Reserve Bank of Kansas City on August 30 to September 1, 2007 Housing, housing finance
and monetary policy as well as Jarocinski and Smets (2008) and Iacoviello and Neri (2010), among others.
0165-1889/$ - see front matter & 2013 Elsevier B.V. All rights reserved.
http://dx.doi.org/10.1016/j.jedc.2013.08.002

P. Bofinger et al. / Journal of Economic Dynamics & Control 37 (2013) 28622881

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among others). In these models housing booms and busts merely reflect macroeconomic fundamentals and/or are the
outcome of various structural disturbances.2 To put it differently, in the standard housing DSGE models behavioral
mechanisms, such as Shiller's (2005, 2007) new era story or his notion of emotional speculative interest in the market, do
not play any role in thedetermination of house prices. In contrast, in our Behavioral Expectations (BE) model we take account
for these mechanisms. Thereby, we succeed to implement notions of non-linearities and pronounced boom-bust cycles into
an otherwise standard model.3
Our findings suggest that appropriate policy recommendations and issues of monetary policy design critically hinge on
the degree of rationality of agents. In an environment of bounded rationality we provide evidence that augmented Taylor
rules that respond to the evolution of housing markets are appropriate to prevent the emergence of house price cycles and
its repercussions on the broader economy. In a standard DSGE setting in contrast, these rules do not improve welfare in a
quantitatively important way measured against a prespecified objective function based on the assumption that the ultimate
goal of monetary policy is to reduce real GDP and consumer price variability. Additionally, impulse response analysis reveals
that the effects of monetary policy on the economy are surrounded by uncertainty in the Behavioral Expectations model. In
such an environment augmented Taylor rules proof successful to prevent contagious outbreaks of belief that drive waves of
optimism and pessimism. Given the empirical evidence and success at the micro- and macro level in favor of heterogeneity
in expectations (see Hommes, 2013), standard approaches to issues of monetary policy design that do not account for these
insights, might therefore be systematically ill guided.
Key to our approach is that agents form heterogeneous and biased expectations. In particular, we assume that agents
choose between an optimistic and a pessimistic rule to forecast future real house prices. Thus, at each point in time, some
agents bias the future real house price upwards, while others bias the future real house price downwards. Although agents
systematically have wrong beliefs about future real house prices, they are assumed to behave rationally in the sense that
they base their choice on a continuous evaluation of the forecast performance of both rules (see Anderson et al., 1992; Brock
and Hommes, 1997). Thus, the fraction of house price optimists or pessimists endogenously varies over time. Agents that
were pessimistic (optimistic) about the future track of the real house price cycle might learn that their beliefs were wrong.
Depending on their degree of rationality, they take this as a reason to change beliefs and use the optimistic (pessimistic)
forecasting rule instead. These switches between the two heuristics are of macroeconomic relevance when a large fraction
of agents chooses the same heuristic simultaneously. If such a contagion in beliefs happens, a sustaining house price boom
or bust can be initiated. In a full-fledged model we assume that agents not only use an optimistic and a pessimistic rule to
forecast future real house prices but also to forecast future consumption of nondurable goods and that agents apply simple
inflation-forecasting rules as well (see Brazier et al., 2008; De Grauwe, 2011).
Our modeling strategy is motivated by the recent work of De Grauwe (2010a, 2010b, 2011). He replicates Keynes' notion
of animal spirits by incorporating heuristics into a standard New Keynesian (NK) model. He finds that when agents choose
between an optimistic and a pessimistic rule to forecast future output and adaptively update their beliefs, endogenous and
self-fulfilling waves of optimism and pessimism (animal spirits) can arise in response to economic shocks. Moreover, the
notion of agents using heuristics to guide their behavior can be motivated by a large literature of financial heterogeneous
agent models.4 However, despite their use in many financial market models, the rational representative agent approach is
dominant in macroeconomic models. Recent studies that introduce heterogeneous forecasting rules that may not be fully
optimal in macroeconomic models include Branch and Evans (2006, 2010), Brazier et al. (2008), Branch and McGough (2009,
2010), Guse (2010), Massaro (2013) and Anufriev et al. (forthcoming).
In deriving the DSGE framework, we build on the recent strand in the housing DSGE literature that extends the standard
NK model with a housing sector and a collateral constraint tied to housing along the lines of Kiyotaki and Moore (1997) and
Iacoviello (2005). In this model housing has two features: first, it provides housing services and thus utility, and second, for
a fraction of households it serves as collateral in the credit market. With respect to the exogenous driver of the business
cycle we follow the arguments of Taylor (2007), among others. Taylor (2007) identifies the exceptionally low short-term
interest rates during the period of 20032006, compared to what a Taylor rule would have recommended, as a policy
mistake that significantly contributed to the U.S. housing boom. Using a Bayesian vector autoregressive model Jarocinski and
Smets (2008) find that the Fed's easy monetary policy from 2002 to 2004 contributed to the boom in the U.S. housing
market, but the impact on the overall economy was limited. More recently, Iacoviello and Neri (2010) study the sources and
consequences of fluctuations in the U.S. housing market by using an estimated DSGE model. They show that while monetary
policy played a minor role in the run-up of house prices, it accounted for the entire reversal of house prices from 2005
to 2006. Moreover, they find that housing market spillovers are non-negligible and occur largely through the effects
that fluctuations in house prices have on consumption. This finding is in line with the notion of collateral constrained
households. Consider, for the sake of argument, an expansionary monetary policy shock. When house prices are more
flexible than consumer prices, expansionary monetary policy increases the real house price and thereby increases the

See Williams (2011) for a brief discussion.


Note that there are other approaches to model expectations driven endogenous cycles that relate the emergence of volatility in expectations to
concepts of animal spirits and market psychology (see Grandmont, 1986). Also in this vein is the literature by Azariadis (1981), Benhabib and Farmer (1994)
and Farmer and Guo (1994). This class of models traces back business cycles to the notion of multiple equilibria and sunspots and thus accommodate nonfundamental stochastic cycles driven by random shocks.
4
See LeBaron (2006) and Hommes (2006) for detailed surveys.
3

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P. Bofinger et al. / Journal of Economic Dynamics & Control 37 (2013) 28622881

collateral value of debtors. This allows borrowers to raise consumption of nondurable goods and housing, which, in turn,
reinforces the increase in the real house price. Thus, relative to the standard NK model the positive effect of an expansionary
monetary policy shock on the broader economy is amplified through the impact of the shock on real house prices that
determine the borrowing capacity of borrowers (asset price channel).
In our BE model the propagation mechanisms of monetary policy works as follows. As in the standard DSGE model with
Rational Expectations (RE model) the asset price channel amplifies the effects of expansionary monetary policy shocks on
real house prices and the business cycle. With increasing real house prices, however, the forecasting performance of house
price optimists improves relative to pessimists. Therefore more and more agents switch to the optimistic forecasting rule
and a sustained upward spiral of optimism about future real house prices, higher credit availability, higher demand and
increasing real house prices kicks in. Alongside the boom, beliefs about future nondurable goods consumption and
consumer price inflation change as consumption of nondurable goods and consumer price inflation rise and feed back into
the economy. A comparison of the monetary transmission mechanism between our BE model and the standard RE model by
means of impulse response analysis reveals three important results. First, we find that in the BE model the effects of a
monetary policy shock on real house prices and the business cycle are surrounded by uncertainty. Second, in the BE model
the dynamics in response to a monetary policy shock exhibit a much higher persistence as in the RE model. The relatively
high persistence in the BE model is due to the fact that agents only gradually adapt their beliefs. The high persistence holds
particularly true when a monetary policy shock triggers a wave of optimism or pessimism. Third, we find that in the BE
model consumer price inflation is relatively stable in the early stage of the boom following a monetary policy shock. Thus,
standard monetary policy does not counteract the boom in house prices. Therefore we suggest that in our BE model there is
a meaningful role for a real house price-augmented Taylor rule as it helps to rule out that monetary policy itself becomes a
major source of economic disturbance. When the central bank sets interest rates in accordance with real house price
developments, it reduces the scope for the emergence of optimism and pessimism about real house prices and thus limits
the repercussions of these emotions on the business cycle. As behavioral mechanisms are not present in the standard RE
model we find that the merits of augmenting the Taylor rule with a real house price component is underestimated.
The paper is structured as follows. In the next section, we derive a standard housing DSGE model. The formation of
behavioral expectations is presented in Section 3. Section 4 motivates the parameterization of the model parameters.
Section 5 presents the business cycle dynamics of the BE model. In Section 6, we compare the properties of the BE model to
those of the RE model. In Section 7, we discuss the implication for monetary policy. Section 8 concludes.
2. An NK model with a housing market and a collateral constraint
The theoretical framework is a simplified two-sector NK model with a collateral constraint tied to housing. The
household side of the economy is split into two groups according to their preference for current consumption. A fraction
1 of agents is patient and is named as savers. The remaining fraction is impatient and is labeled as borrowers. Both
types receive utility from consumption of nondurable goods and housing and disutility from labor supply. Borrowers are
assumed to face a binding collateral constraint that ties their borrowing limit to the expected present value of their future
housing stock times a loan-to-value ratio. The production side of the economy consists of two sectors producing nondurable
goods and housing. In each sector there is a continuum of intermediate goods producers and final goods producers. While
the former produce imperfectly substitutable intermediate goods and have some market power, the latter operate in perfect
competition.5
In what follows, we derive the maximization programs of savers, borrowers and firms. We assume that each market is
in equilibrium and close the model by assuming that the central bank follows a Taylor-type interest rate rule. As we will
implement heuristics into the standard DSGE framework starting from its linearized version, we finally describe all
log-linearized equations of the model for the sake of clarity. Note that all variables and parameters referring to borrowers
are labeled with a tilde.
2.1. Savers
k
Each saver s s A ; 1 maximizes an intertemporal utility function, Et 1
k 0 U tk s, where Et is the expectation
operator, is the discount factor and Ut(s) is the period utility function, which is defined as

U t s 1 log C t shC t1 log H t s

Lt s1
:
1

5
The DSGE framework used in this paper builds on that developed by Monacelli (2009) who studies the implications of credit market imperfections in
a NK model for the co-movement properties of nondurable and durable spending in response to monetary policy shocks. To reduce the overall model
complexity, we follow Monacelli (2009) and abstract from nonhousing capital formation and sticky nominal wages as is generally modeled in the empirical
literature (see Iacoviello, 2005; Paris and Notarpietro, 2008; Iacoviello and Neri, 2010). In contrast to Monacelli (2009), our model features habit formation
in consumption of nondurable goods such that the RE model is able to generate a sufficient degree of persistence in total output. Our model also accounts
for an imperfect substitutability of labor supply across sectors, which dampens the volatility of residential investment in response to monetary policy
shocks (see Iacoviello and Neri, 2010; Aspachs-Bracons and Rabanal, 2010, 2011). Aspachs-Bracons and Rabanal (2010, 2011) provide a two-country setup
for a similar model used in this paper.

P. Bofinger et al. / Journal of Economic Dynamics & Control 37 (2013) 28622881

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Ct(s) stands for the consumption of nondurable goods, Ht(s) is housing (end-of-period housing stock) and Lt(s) is a labor
supply index. The parameter h governs the importance of the habit stock, which is the past aggregate consumption
of nondurable goods, is the share of housing in total private consumption and is the inverse elasticity of labor supply.
Following Aspachs-Bracons and Rabanal (2010), the labor supply index is defined as
Lt s 1H L LC;t s1L H L LH;t s1L 1=1L ;

L Z0;

where LC;t s and LH;t s denote the labor supply in the nondurable goods and housing sector, respectively. H is the share of
real residential investment in total output and L governs the degree of labor mobility across sectors.6 Savers accumulate
housing according to
H t s HI t s 1H t1 s;

where HIt(s) is the real residential investment and is the depreciation rate. In real terms (units of the nondurable goods)
the period budget constraint of a saver is
C t s qt HIt s bt s Rt1

bt1 s
wC;t LC;t s wH;t LH;t s divt s;
C;t

where qt P H;t =P C;t is the real house price defined as the ratio of the price of nondurable goods, P C;t , and the price of
housing, P H;t . bt s Bt s=P C;t is real one-period debt, C;t P C;t =P C;t1 depicts the gross inflation rate of consumer prices
and Rt is the gross nominal interest rate of contracts entered in period t. wj;t W j;t =P C;t is the sectoral real wage rate and
divt s Divt s=P C;t are dividends paid by intermediate goods producers because firms are owned by savers.
By defining U C;t s U t s=C t s as the marginal utility of an additional unit of nondurable goods and U H;t s U t s=
H t s as the marginal utility of an additional unit of housing, the first-order conditions to the maximization of the
intertemporal utility function with respect to (3) and (4)are7
wC;t

LtL 1H L LC;t L


;
U C;t

wH;t

LtL H L LH;t L
;
U C;t

U C;t qt U H;t 1Et U C;t1 qt1



Rt
and U C;t Et U C;t1
:
C;t1

2.2. Borrowers
~k ~
~
Each borrower b b A 0;  maximizes an intertemporal utility function, Et 1
k 0 U tk b, where o. The period utility
function, the labor supply index and the housing accumulation equation have the same functional form as (1)(3),
respectively. The real budget constraint of a borrower is given by
~
~ t b Rt1 b t1 b b~ t b wC;t L~ C;t b wH;t L~ H;t b:
C~t b qt HI
C;t
Borrowers are subject to a collateral constraint, which is
!
H~ t bqt1
b~ t b r 1 1Et
;
Rt = C;t1

10

where 1 is the loan-to-value ratio.8


The first-order conditions of borrower's maximization program above are given by9
wC;t

L
L~ t
1H L L~ C;t L
;
U~ C;t

11

6
Note that if L 40, labor efforts in the two sectors are less than perfect substitutes. Hence, sectoral labor supply responses less to differences in
sectoral wages in response to a monetary policy shock (see also Iacoviello and Neri, 2010).
7
We assume that savers trade state-contingent securities among each other. Thus, all savers behave the same way and we drop the index s.
8
It can be shown that the collateral constraint is satisfied with equality in the deterministic steady state. Throughout we follow the general
assumption in the literature and assume that the constraint is also binding in a small neighborhood of the steady state so that the model can be solved by
taking a log-linear approximation (see Iacoviello, 2005; Monacelli, 2009).
9
We drop the index b as it is assumed that borrowers trade state-contingent securities.

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P. Bofinger et al. / Journal of Economic Dynamics & Control 37 (2013) 28622881

wH;t

L
H L L~ H;t L
L~ t
;
U~ C;t

12

~
~
~ t U~ C;t Et H;t1
U~ C;t qt U~ H;t 1E
t U C;t1 qt1 11qt

13



~ t U~ C;t1 Rt
Rt ~ t U~ C;t ;
and U~ C;t E
C;t1

14

where H;t qt =qt1 C;t is the gross inflation rate of house prices and ~ U~ C;t is the Lagrange multiplier on the collateral
constraint.
2.3. Final goods producers
In each sector (j C; H) final goods producers purchase units of the intermediate goods i and bundle them according
R1
to the following technology Y j;t 0 Y j;t ij 1=j dij =j 1 ; where Y j;t is the quantity of final goods, Y j;t i is the quantity of
intermediate good i and j is the elasticity of substitution between intermediate goods. Profit maximization by the final
goods producers implies a demand function for the intermediate good i according to Y j;t i P j;t i=P j;t j Y j;t ; where P j;t i is
R1
the price of one unit of the intermediate good. Given zero profits in equilibrium, it holds that P j;t 0 P j;t i1j di1=1j .
2.4. Intermediate goods producers
In each sector intermediate goods are produced according to the following linear production technology Y j;t i Ltot
j;t i,
where Ltot
j;t i stands for total labor input. Intermediate goods producers maximize expected profits in each period subject to
the demand for intermediate goods. As in Calvo (1983), intermediate goods producers in sector j C; H reset prices with a
probability of 1j . Thus, the reset price for good i in sector j is given by

P nj;t i

j
k
1
j Et k 0 j U C;tk P j;tk mcj;tk iY j;tk
;
1
k
j 1
Et 1 j U
Pj Y

k0

C;tk j;tk

15

j;tk

where mcj;t are the real marginal costs of production defined as mcj;t W j;t =P j;t . Finally, the aggregate price level in each
1
sector can be written as P j;t j j P j;t1 1j 1j P nj;t i1j .
2.5. Market clearing and monetary policy
We assume that each market is in equilibrium and the nominal interest rate is determined by a central bank that follows
a simple Taylor-type rule, which is
 
   1R


C;t Y t Y
R
R
exp uR;t ;
16
Rt Rt1
C
Y
where R stands for the steady state gross nominal interest rate, C 1 is the steady state gross inflation rate of consumer
prices, Y denotes the steady state real GDP and uR;t is an i.i.d. monetary policy shock with zero mean and variance s2uR .
2.6. The linearized model
Here, we summarize all log-linearized equations of the model and provide a brief description of basic mechanisms. Note
that in the following variables with a bar denote steady state values and variables with a hat describe log-deviations from
steady state values.10
The dynamics of consumption of nondurable goods for savers are standard and read

1
h ^
1h  ^
Et C^ t1
C t1 
R t Et C;t1 :
17
C^ t
1h
1h
1h
The dynamics of the savers' demand for housing depend on past and current consumption of nondurable goods, the (ex-ante)
real interest rate and the current and expected future real house price and follow
n

o
1 ^
h ^
18
Ct
C t1 H^ t 111 q^ t 1 R^ t Et C;t1 Et q^ t1 :
1h
1h
The accumulation equation of the savers' housing stock is determined by
^ t 1H^ t1 :
H^ t HI
10

In Appendix A, we present the steady state of the model.

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The savers' sectoral labor supply is


1 ^
h ^
^ C;t
Ct
C t1 L 1H L L^ C;t L H L^ H;t w
1h
1h

20

1 ^
h ^
^ H;t :
Ct
C t1 L H L L^ H;t L 1H L^ C;t w
1h
1h

21

Due to the effects of the collateral constraint, the borrowers consumption of nondurable goods is more responsive to monetary
policy than that of savers. It holds that
^
C~ t

 ~ 1h 

1
h ~^
1h  ^
^
Et C~ t1
C t1 
R t Et C;t1 
R^ t ~^ t ;
1h
1h
1h
~ 1 h

22

~ Similarly, the presence of the collateral constraint alters the dynamics of the borrowers' housing demand
where ~ .
relative to that of savers by delinking the demand for housing from movements in real house prices. The borrowers' demand for
housing follows:
n



o
1 ~^
h ~^
^
~ t q^ t1 R^ t Et C;t1 ~ ~^ t ^ t ;
~ 1 ~ q^ t E
23
C t
C t1 H~ t
1h
1h
where
~

1
;
~
11~ 1

~
111
~
1

and ^ t is a composite inflation term, which is defined as ^ t 1Et q^ t1 q^ t Et C;t1 .11 The law of motion for real debt
holdings depends on the housing stock, the real interest rate and the expected real house price and reads
^
^
b~ t H~ t Et q^ t1 R^ t Et C;t1 :

24

The accumulation equation of the borrowers' housing stock and the sectoral labor supply is equal to (19)(21). The borrowers'
budget constraint is

 C;H




^ b~
^
^
^
~^ t :
~ q^ HI
^ j;t HI
C~ C~ t b~ b~ t  R^ t1  C;t b~ t1 W j L~ j L~ j;t w
t

25

The dynamics of the real house price are given by


q^ t H;t  C;t q^ t1 :

26

The evolution of inflation in each sector takes the form of a forward-looking New Keynesian Phillips curve
C;t Et C;t1

1C 1C
^ C;t
w
C


 1H 1H 

^ H;t q^ t ;
w
and H;t Et q^ t1 q^ t Et C;t1
H

27

28

where we have used that Et H;t1 Et q^ t1 q^ t Et C;t1 .


The labor market equilibrium condition can be written as
L~ j ^
1L j ^
L j;t ;
Y^ j;t L~ j;t
Yj
Yj

j C; H:

29

The debt market equilibrium condition is described by


^
b~ t b^ t :

30

The goods market equilibrium conditions are


1C ^
C~ ^
Y^ C;t C~ t
Ct
YC
YC
and

~ ^
HI
~ t 1HI HI
^ t:
HI
Y^ H;t
YH
YH

31

32

11
See Monacelli (2009) and Calza et al. (forthcoming) for a detailed discussion on the implications of the collateral constraint for the transmission of
monetary policy in a standard NK model.

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Real GDP evolves as


Y^ t 1H Y^ C;t H Y^ H;t :

33

Finally, the Taylor rule for nominal interest rate reads


R^ t R R^ t1 1R C;t Y Y^ t uR;t :

34

3. The formation of expectations


In this section, we discuss how agents, i.e., savers, borrowers and firms, form their expectations of future real house
prices, consumption of nondurable goods and consumer price inflation. Throughout we assume that agents choose between
simple rules to make forecasts and base their choice on the relative forecast performance of these rules. The diversity in
beliefs is a key difference to a standard RE model in which expectations are homogeneous. Following De Grauwe (2010a,
2010b, 2011), we impose heuristics at the macroeconomic level. That is, we use the linearized version of the model
described in the previous section and assume that structural equations remain unchanged when we substitute the
assumption of rational expectations for the alternative that agents choose among different rules to form their expectations.12 In this vein, our Behavioral Expectations (BE) model has the same macroeconomic relationships as the standard
model, except that rational expectations are replaced with aggregate forecasts that are a combination of the rules agents use
to make forecasts.13
3.1. Expectations on future real house prices and consumption of nondurable goods
When agents form expectations (i.e., on real house prices) our workhorse hypothesis is that they face cognitive
limitations (see De Grauwe, 2011). Concretely, we assume that they are intellectually not capable to condition the future
evolution of variables on the structure of the economic model and the distribution of shocks. Instead, we conjecture that
agents rely on simple, but biased rules to forecast future house prices and consumption of nondurable goods. To get started
we assume a simple setting where agents may choose between three different rules as in De Grauwe (2010a, 2010b). Agents
may be optimistic. Optimism means that agent's believe house prices to be higher than the long run fundamental value (i.e.,
the steady state), which is normalized to zero. Symmetrically we assume that a fraction of agents is pessimistic on the future
course of the real house price and forecasts house prices to be lower than the long run fundamental value. Concretely
optimism and pessimism are defined as follows14:
^
Eopt
t q t1

dt
2

and

dt
^
Epes
t q t1  ;
2

35

where dt 4 0 measures the absolute divergence in beliefs, which is assumed to be a function of real house price volatility.
q
The key difference to a setting with rational expectations is twofold. First, agents have heterogeneous belief and dt 4 0
measures the absolute divergence in beliefs, which is assumed to be a function of the real house price and reads
dt d d sq^ t ;
q

36

where sq^ t is the unconditional volatility of house prices measured over a window of z observations in the past, d 4 0
denotes the average divergence in beliefs and d 4 0 is the sensitivity of the divergence in beliefs to volatility (see
De Grauwe, 2011). Second, as the share of optimists and pessimists is time varying swings between the camps of optimists
and pessimists are key to understand macroeconomics dynamics in the behavioral model. Thus, the assumption that agents
choose between an optimistic and a pessimistic forecasting rule formalizes Kohn's (2007) idea of the excessive optimism
followed by fear as a potential driver of the recent U.S. house price boom and bust.15 In addition to the optimistic and the
pessimistic rule, it is assumed that agents may choose a fundamental rule to form their beliefs on future real house prices
similar to the approach in behavioral financial market models (see,for instance, Brock and Hommes, 1998). Fundamentalists
forecast house prices equal to the long run fundamental value (i.e., the steady state). The fundamental heuristic may be
12
This also follows the approach within statistical learning models pioneered by Evans and Honkapohja (2001). See, e.g., Bullard and Mitra (2002),
Orphanides and Williams (2004), Gaspar et al. (2006), Milani (2007) and Branch and Evans (2010). In contrast to our model in which agents systematically
have biased beliefs, those models might nest the RE equilibrium depending on the statistical tools and knowledge agents use to form expectations.
13
Note that the implementation of bounded rationality and heterogeneous expectations at the aggregate level as in De Grauwe (2010a, 2010b, 2011) is
based on strong assumptions as the log-linearized equations are derived under the assumption of repeatedly asserting the rationality of agents which
implies that the law of iterated expectations holds. A micro-foundation to the approach how to include heterogeneous expectations and rational
expectations in the light of cognitive limitations in a NewKeynesian framework has recently been given by Massaro (2013) which encompasses the
representative agent model as a special case.
14
As we assume that savers and borrowers are equally distributed among house price optimists and pessimists, which leads the expectations of savers
and borrowers to be equal on the aggregate level, we use the general term agents.
15
As we will see later, the assumption that agents form optimistic and pessimistic beliefs about future house prices also incorporates the notion of a
social epidemic of optimism for real estate that contributed to the U.S. house price bubble as described by Shiller (2007).

P. Bofinger et al. / Journal of Economic Dynamics & Control 37 (2013) 28622881

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interpreted as a fundamental rule as it is unconditionally unbiased. A high fraction of fundamentalists may counteract the
emergence of purely expectations-driven housing boom-bust cycles. The fundamental rule reads as follows:
^
Efun
t q t1 0:

37

Note importantly that the notion of heterogeneous belief implies a permanent evolutionary competition between alternative rules.
Thus the fundamental rule is not the rational forecast as it would imply amongst others, that fundamentalists take into account
how other agents form expectations and condition forecasts on the current state of the economy. Therefore, in periods of a boom
agents that opt to choose for the optimistic rule will outperform agents that stick to the fundamental heuristic. To that extend the
degree of rationality is equally spread between all camps of agents and reflected in the ability of agents to learn from past mistakes
and to change beliefs accordingly. Concretely, which rule should agents choose?
Which rule should agents choose? This decision is modeled by applying notions of discrete choice theory (see Anderson et al.,
1992; Brock and Hommes, 1997). Although agents are assumed to have cognitive limitations and use simple forecasting rules,
they behave rationally in the sense that they select the rules according to their recent forecast performance. Agents evaluate the
corresponding forecast performance of the three rules according to
1

U qopt;t k q^ tk Eopt


q^ 2 ;
tk1 tk

38

k1
1

q^ 2
U qpes;t k q^ tk Epes
tk1 tk

39

k1

and

q^ 2 ;
U qfun;t k q^ tk Efun
tk1 tk

40

k1

where U qopt;t and U qpes;t are the mean squared forecasting error (MSFE) of the optimistic, respectively, the pessimistic rule and
U qfun;t is the MSFE of the fundamental rule. k are geometrical declining weights. It holds that wk 1k , where governs the
memory of agents. The fraction of agents using the optimistic, pessimistic or fundamental forecasting rule is then determined by
qopt;t

qpes;t

and

expU qopt;t

;
expU qopt;t expU qpes;t expU qfun;t

41

expU qpes;t

42

expU qopt;t expU qpes;t expU qfun;t

qfun;t

expU qfun;t
expU qopt;t

expU qpes;t expU qfun;t

1qopt;t qpes;t ;

43

where the parameter is the so-called intensity of choice. This parameter measures the degree of agents' rationality.
The higher , the higher the fraction of agents choosing the better performing rule.16 The limit 0 is the case in which the
fraction of optimists or pessimists is 0.5 (independent of the MSFEs) and 1 represents the case in which all agents choose the
rule with the highest forecast performance.
Finally, the aggregate real house price forecast, Et q^ t1 , is defined as the weighted average of the three forecasts and is
given by
q
pes
q
fun
^
^
^
Et q^ t1 qopt;t Eopt
t q t1 pes;t Et q t1 fun;t E t q t1 :

44

Given this line of argument for the modeling of the formation of beliefs on future house prices, we also assume that
agents choose among these three types of rules when they forecast their future level of nondurable goods consumption and
that they base their choice on the relative forecasting performance among rules. On one side, we do so to keep the modeling
assumptions about the formation of expectations as parsimonious as possible. On the other side, it is reasonable to do
so because the selection mechanism as described above can be viewed as a natural way to limit the classes of competing
forecasting rules. As, however, the consumption of nondurable goods differ between savers and borrowers we separate the
expectation formation between these two types. That is, borrowers and savers separately choose between an optimistic, a
pessimistic and a fundamental forecasting rule. Similar to the formation of beliefs on future real house prices, the divergence
in beliefs on future nondurable goods consumption implied by the optimistic and pessimistic rule is symmetric around zero
and a function of the unconditional volatility of nondurable goods consumption measured over a fixed window in the past.
16
The intensity of choice can be related to noise agents face when they compute the forecast performance of rules (see Anderson et al., 1992 and Brock
and Hommes, 1997). The higher is , the lower is the noise in observing the forecast performance and the higher is the fraction of agents that uses the
better performing rule.

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P. Bofinger et al. / Journal of Economic Dynamics & Control 37 (2013) 28622881

The fundamental rule is independent of the movement in nondurable goods consumption and uses the steady state value of
nondurable goods consumption as a predictor.17
Essentially, the aggregate forecast of future consumption of nondurable goods for savers, Et C^ t1 , is given by
pes ^
fun ^
C
C
^
Et C^ t1 Copt;t Eopt
t C t1 pes;t E t C t1 fun;t E t C t1 :

45

^
Accordingly, the aggregate forecast on future consumption of nondurable goods for borrowers, Et C~ t1 , is
~
^
pes ~^
fun ~^
C~
C~
~^
Et C~ t1 Copt;t Eopt
t C t1 pes;t E t C t1 fun;t Et C t1 :

46

3.2. Expectations of future consumer price inflation


Agents also form expectations of future inflation rate in the nondurable goods sector.18 For the formation of future
consumer price inflation expectations we follow Brazier et al. (2008) and De Grauwe (2011) and deviate from the
assumption of optimistic or pessimistic forecasting rules. In particular, in our setting agents may choose between two
heuristics, one forecasts consumer price inflation equal to the announced inflation target of the central bank and the second
type is a naive forecast that equates expected inflation to the last available data-point. The two forecasting rules are given by
n
Etar
t C;t1 C

and

Eext
t C;t1 C;t1 ;

47

where C is the central bank's inflation target, which is normalized at zero. The deviation from the rational expectations
hypothesis in turn is well founded on ample evidence from survey data and laboratory experiments which report evidence
in favor of heterogeneous expectations in general and for the formation of inflation dynamics in specific (see, e.g., Hommes,
2013 and Cornea et al., 2012). The targeting heuristic may be interpreted as a fundamental rule as it is unconditionally
unbiased. A high fraction of targeters indicates the belief that the targeting heuristic produces better forecasts and may thus
be interpreted as an indicator of central bank credibility. Note however that the targeting heuristic, which we referred to as
a fundamental rule, does not imply rational expectations. A rational forecast would require fundamentalists amongst others
to take into account how other agents form expectations. Moreover the naive forecast outperforms the fundamental forecast
when the inflation process exhibits near unit root behavior. The permanent evolutionary competition between alternative
heuristics is supported by Cornea et al. (2012) who report evidence for U.S. inflation dynamics that the evolution of the
inflation rate is at some times dominated by fundamentalists while at other times by backward-looking behavior. The
selection mechanism is identical to the previous formations of expectations. Agents evaluate the forecasting performance of
the two rules according to
1

2
U tar;t k C;tk Etar
tk1 C;tk 

48

k1

and

2
U ext;t k C;tk Eext
tk1 C;tk  ;

49

k1

and the fractions of agents evolves as


tar;t

and

expU tar;t
expU tar;t expU ext;t

ext;t

expU ext;t
1tar;t ;
expU tar;t expU ext;t

50

51

where tar;t is the fraction of agents that uses the inflation target of the central bank and ext;t is the remaining fraction that
uses the past inflation rate.
Finally, the aggregate forecast for inflation in the nondurable goods sector, Et C;t1 , is given by
ext

Et C;t1 tar;t Etar


t C;t1 ext;t Et C;t1 :

52

4. Calibration and solution


We calibrate the model by applying parameter values that are typically reported in the housing DSGE literature. Time is
considered in quarters. The discount rate of savers, , is assumed to be 0.9925, which implies an annual real rate of return
17

We present the modeling details in Appendix B.


Again, we assume that savers and borrowers are equally distributed among the forecasting camps, such that borrowers and savers have the same
expectations on the aggregate level.
18

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~ is set to 0.97. The share of borrowers in the economy, , is fixed at 50%. Habits in
of 3%. The discount factor of borrowers, ,
consumption, h, the inverse elasticity of labor supply, , and the parameter governing the degree of labor mobility across
sectors, L , are equal for both households and are set to 0.7, 1 and 1, respectively. As Aspachs-Bracons and Rabanal (2010)
note, the steady state share of real residential investment in real GDP, H , and the parameter , which denotes the share
of housing in total private consumption for all types of households, cannot be set independently. We determined
numerically, such that H 0:1. The annual depreciation of housing is 4%, which implies 0:01. The parameter is 0.25,
which yields a LTV ratio of 75%. The elasticities of substitution between intermediate goods, C and H , are both set to 11
which yields a steady-state mark-up of 10% in each sector j C; H. The degrees of price stickiness, C and H , crucially
determine the dynamics of the model. Throughout we follow the assumption that house prices exhibit greater flexibility
than nondurable goods prices. However, we do not allow for fully flexible house prices.19 We choose to set C 0:8, which
implies an average frequency of price adjustment of 5 quarters for nondurable goods prices, and H 0:667, which yields an
average price rigidity of 3 quarters for house prices. Turning to the monetary policy rule, we set R 0:75, 1:5 and
Y 0 in the baseline calibration. For the parameters governing the formation of expectations, our calibration strategy is to
choose parameter values that maximize the correlation between the movements in the fraction of house price optimists and
the real house price gap. We set the fixed component and the variable component of the divergence in beliefs, d and d ,
such that d 2 and d 2. The intensity of choice parameter, , is equal to 1. The memory parameter, , is assumed to be 0.5
and the number of past observations that are used to evaluate the forecast performance of the rules, z, is 20.20 Finally, to
simulate from the model, we place the model in the following form:
Zt A1 BEt Zt1 CZt1 Vt ;

53

where A, B, C are appropriately defined parameter matrices, Zt denotes the state vector that contains the relevant variables
of the system and Vt is a vector that includes the monetary policy shock.
5. Monetary policy, animal spirits and the business cycle
In this section, we investigate the business cycle dynamics of the model and study the role of the heuristics agents use to
make forecasts in the transmission of monetary policy. In particular, we analyze the extend to which monetary policy shocks
can trigger waves of optimism and pessimism (animal spirits) that drive house prices and the real economy.
5.1. A simplified BE model
We first shed some light on the role of behavioral mechanisms in a somewhat simplified model. To eliminate
the possibility that endogenously driven business cycles arise due to behavioral mechanisms when agents form beliefs
regarding future consumption and consumer price inflation, we assume that these expectations are fixed at their steady
^
state value. That is, we set the expectation operator on future consumption of nondurable goods, Et C^ t1 and Et C~ t1 , and on
future consumer price inflation, Et C;t1 , to zero. A way to rationalize the simplified model is by assuming an economy in
which agents form optimistic or pessimistic expectations when they predict the future movements of real house prices,
while they form fundamentally grounded expectations on future consumption levels of nondurable goods and consumer
price inflation. In that sense, the analysis in this section boils down to the interaction between macroeconomic dynamics
and behavioral expectations that only play a role for the determination of asset prices.
Fig. 1 highlights the dynamics of the model between quarter 700 and 800 for an arbitrary draw of i.i.d. monetary policy
shocks with a standard deviation of 25 basis points. As is apparent from the figure, the BE model is capable to generate
endogenous and persistent cycles in real house prices and the broader economy although they are only driven by uncorrelated
monetary policy shocks.
The monetary transmission mechanism can be described as follows. Between quarter 710 and 720, we observe that the
economy is hit by a sequence of negative monetary policy shocks such that the interest rate is well below its steady state for
a sustained period of time. As prices are sticky, the real interest rate is low and stimulates demand for nondurable goods and
residential investment, which, in turn, causes consumer price inflation and house prices to rise as marginal costs increase
alongside the expansion. Because firms in the housing sector are able to adjust prices more frequent than firms in the
nondurable goods sector, the real house price increases. With increasing real house prices agents who are pessimistic about
the future track of real house prices gradually observe that their forecast performance deteriorates. Therefore, pessimists are
willing to change their beliefs and switch to the fundamental forecasting rule first. In response to the decreasing pessimism
about future real house prices, firms in the housing sector adjust their prices upwards. Moreover, the decreasing pessimism
about future real house prices increases the collateral value of borrowers which allows them to expand their debt holdings
19
In a seminal paper, Barsky et al. (2007) show that the standard NK model with a full flexibly priced durable goods sector does not replicate the
empirically observed positive co-movement of nondurable and durable consumption following a monetary policy shock. In response, Monacelli (2009)
points out that the introduction of a collateral constraint on borrowing makes the assumption on the degree of stickiness in the durable sector less crucial.
In general, the collateral constraint model reproduces a positive co-movement in response to a monetary policy shock when a sufficient degree of price
stickiness in the durable sector is allowed for.
20
In Appendix C, we outline our calibration strategy for the behavioral parameters and present a sensitivity analysis.

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Fig. 1. Dynamics of the simplified BE model. Note: the x-axis is in quarters. The y-axis measures percent deviation from the steady state except in the
AS plot. AS stands for animal spirits and measures the fraction of real house price optimists (solid line) and fundamentalists (dashed line).

in order to raise consumption of nondurable goods and housing investment. The additional demand strengthens the rise in
real house prices and reinforces more and more agents to switch to the fundamental or even the optimistic forecasting rule.
After a while, the forecasting performance of the fundamental forecasting rule deteriorates relative to the optimistic rule
such that agents go over to use the better performing rule. This contagion in beliefs and its feedback on the business cycle
then creates a sustained boom. At some point in time, however, positive monetary policy shocks and the endogenous
reaction of the central bank through the Taylor rule lead to a turn around in the business cycle and the formation of beliefs.
High real interest rates around quarter 740 strongly depress the consumption of nondurable goods and housing investment.
In turn, real house prices fall below its steady state inducing agents to be less optimistic about the future track of real house
prices. As the fraction of house price pessimists increases real house prices slump carrying down the broader economy, all in
a self-reinforcing fashion.
5.2. A full-fledged BE model
Clearly, it can be argued that the assumption of agents expecting future consumption of nondurable goods and consumer
price inflation to be at their steady state and simultaneously being optimistic or pessimistic about future real house prices is
somewhat unrealistic as it implies that agents do not internalize the impact of changing real house prices. In this section, we
repeat the simulation exercise in the previous section by assuming that all behavioral expectation operators are at play.
Fig. 2 shows the dynamics of the full-fledged BE model for the same draw of monetary policy shocks as used in the
simplified BE model.
The business cycle dynamics of the full-fledged model are amplified relative to the dynamics of the simple model. In the
full-fledged model biased expectations about future nondurable goods consumption and consumer price inflation feed back

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Fig. 2. Dynamics of the extended BE model. Note: the x-axis is in quarters. The x-axis is in quarters. The y-axis measures percent deviation from the steady
state except in the AS plots. AS stands for animal spirits and measures the fraction of corresponding optimists (solid line) and fundamentalists,
respectively, inflation targeters (dashed line).

into the economy through their effects on the current behavior of agents and thus reinforce business cycle fluctuations
through their self-fulfilling mechanism. Moreover, expectations about future real house prices play the dominant role in
the transmission mechanism of monetary policy. Because borrowers are subject to a collateral constraint, swings in beliefs
about future real house prices have a strong impact on the borrowers consumption of nondurable goods. Thus, the waves
of optimism and pessimism about future nondurable goods consumption among borrowers follow the waves of optimism
and pessimism about future real house prices and amplify the effects of the latter on the borrowers nondurable goods
consumption. Savers, however, are not credit constrained and thus house price optimism or pessimism does not dominate
the swings in beliefs about their future consumption of nondurable goods. As savers have access to perfect credit markets,
movements in the real interest rate are an important factor in the determination of their current nondurable goods
consumption and thereby their optimism or pessimism about their future nondurable goods consumption. However, swings
in beliefs about future real house prices are not completely irrelevant for savers. As rising real house prices induce savers to
substitute for housing with nondurable goods consumption and vice versa, self-fulfilling swings in beliefs about future real
house prices amplify the swings in beliefs about future nondurable consumption. The fraction of agents that uses the central

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bank's inflation target to forecast consumer price inflation levels off at 50%. Consequently, at each point in time 50%
of agents use the last period's consumer price inflation rate to forecast future inflation, which, together with the higher
volatility of the output cycle, lead to a more pronounced cycle in consumer price inflation as in the simple BE model in
which all agents expect the future consumer price inflation rate to be at the central bank's target level. In contrast to the
formation of expectations about future real house prices or nondurable goods consumption the fluctuations in consumer
price inflation do not lead to swings in beliefs. Clearly, as the central bank sets interest rates in accordance with consumer
price inflation, it dampens the scope within which animal spirits can arise a priori. However, given small fluctuations in
consumer price inflation, the central bank's inflation target is not fully credible. This induces agents to be doubtful about
future inflation, such that their decision of whether to use the central bank's inflation target or to extrapolate from past
inflation to forecast future consumer price inflation is almost random.
6. BE model vs. RE model
In the previous section, we showed that in the BE model monetary policy shocks might trigger waves of optimism
and pessimism that drive house prices and the broader economy. A contagion among the beliefs of agents leads to an
environment in which a large fraction of agents systematically biases the future track of real house prices upwards or
downwards, which, in turn, has strong repercussions on the business cycle. Clearly, such features are not present in the
standard RE model. When agents have rational expectations and perfect information they know the underlying structure of
the economy and the distribution of shocks. Thus, rational agents do not make systematic forecast errors. In this section, we
discuss the implications of heuristics vs. rational expectations for the monetary policy transmission mechanism. We do so
by means of impulse response analysis.
The peculiarity of the BE model is that it is highly non-linear. To account for this, we borrow from De Grauwe (2011)
while computing impulse responses. First, we simulate the model economy over 720 quarters, where we fix the monetary
policy shock in quarter 700 at a level of  25 basis points. Second, we keep the stochastic draws of monetary policy shocks
and repeat the simulation exercise, while we set the monetary policy shock in period 700 equal to 0. Third, for each variable
of interest we compute the difference between the first and the second simulation. Thereby we isolate the effect of the
monetary policy shock in quarter 700 on the future development of the economy for a given state of the economy in quarter
700 and random disturbances in the subsequent period. It is important to note that the transmission of the monetary policy
shock occurring in quarter 700 depends on the realizations of monetary policy shocks in the pre-700 and post-700 periods.
Intuitively, when the central bank decreases the interest rate by 25 basis points, the further track of the economy will
strongly depend on the fraction of optimists vs. pessimists present at that time. It might be that the shock initiates a wave of
optimism and thus has a large impact on the development of the economy. Then it might be that the same shock has only a
minor effect on the economy. This might be the case when the fraction of optimists is already large. In line with this, the
realizations of monetary policy shocks during the post-700 period also affect the transmission of the shock occurring in
period 700. Suppose that the policy rate decreases by 25 basis points in quarter 700 and initiates a wave of optimism.
Whether this wave of optimism evolves and persists for a prolonged period of time strongly depends on the realizations of
the monetary policy shock in the post-shock period. Hence, to take this effect into account, we follow De Grauwe (2011) and
continue to allow for random disturbances in the post-shock period. In a last step we proceed by repeating steps (1)(3)
1000 times, each time with a different realizations of monetary policy shocks. Then, we compute for each variable of interest
the median impulse response together with the 95%- and 5%-quantile.
Fig. 3 portrays the impulse responses of the full-fledged BE and the RE model to an expansionary policy shock of 25 basis
points. Three important results can be found. First, we find that in the BE model the effects of a monetary policy shock on
real house prices and the broader economy are highly uncertain.21 On the one side, the expansionary policy shock might
trigger a wave of optimism that leads to a sustained boom in house prices. This might be the case when the shock induces
a large fraction of agents to switch to the optimistic rule to forecast future real house prices, which, in turn, leads in a selfreinforcing fashion to booming house prices and a booming economy. On the other side, it might be that the same
expansionary monetary policy shock has only a minor effect on the further track of the economy. This might be the case
when the fraction of optimists about future real house prices is already large at the time of the shock. To put it differently,
the timing of a monetary policy shock matters in the BE model. Second, the impulse responses of the BE model are much
more persistent than the impulse responses of the RE model. This relatively high persistence results from agents gradually
updating their beliefs. After a monetary policy shock hits the economy, the broader economy slowly adjusts inducing agents
to change their forecasting rule. A contagion among the beliefs of agents might then lead to a sustained boom. This is in
contrast to the representative RE model in which agents completely internalize the effect of the expansionary monetary
policy shock as they are perfectly informed about the structure of the economy and the distribution of the shock. Thus, in
the RE model the initial impact of the shock on the economy is relatively high. Third, but related to point two, the consumer
price inflation in the BE model is relatively stable. As the central bank sets interest rates in accordance with consumer price
inflation it reduces the scope in which large swings in beliefs about future inflation to arise a priori. However, this has
a crucial implication for the conduct of monetary policy in response to the booming economy which is triggered by
21

See De Grauwe (2011) for a similar result for the standard NK model.

P. Bofinger et al. / Journal of Economic Dynamics & Control 37 (2013) 28622881

2875

Fig. 3. Impulse responses of the full-fledged BE and the RE model to a monetary policy shock of 25 basis points. Note: the x-axis is in quarters. The y-axis is
measured in percent. The dashed lines are the impulse responses of the RE model. The solid lines represent the median impulse responses of the BE model
and the shaded areas stand for the 90% confidence intervals.

monetary policy itself. As the boom in house prices and the broader economy does not lead to rising consumer price
inflation, monetary policy does not counteract the boom by increasing interest rates. Instead, given a Taylor rule in which
consumer price inflation is the most important component, monetary policy is accommodative for a prolonged period of
time, which drive increasing numbers of agents to form optimistic beliefs about future developments.

7. Implications for monetary policy


In this section, we explore to what extend modifications of the Taylor rule can be beneficial in terms of stabilizing
economic fluctuations when behavioral mechanism play a role. Given the prominent role of swings in beliefs about future
real house prices in shaping the business cycle, we propose as a natural candidate that the central bank should set interest
rates in response to real house prices. We therefore suggest the following real house price-augmented Taylor rule:
R^ t R R^ t1 1R C;t Y Y^ t q q^ t uRt :

54

To explore the benefits of an augmented Taylor rule relative to a standard Taylor rule we report how AR(1)-coefficients and
standard deviations of real GDP and consumer price inflation change when we alter the real house price coefficient, q ,
while all other parameters are fixed at their baseline value. Additionally, we report the corresponding statistics for changing
the output coefficient, Y , or the inflation coefficient, , relative to their baseline calibration. We test the values f2; 2:5g
for the inflation coefficient and the values Y f0:25; 0:5g for the output coefficient. As a reference point we repeat this
exercise for the RE model.

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Fig. 4. Augmented Taylor rule: full-fledged BE vs. RE model. Note: The black solid lines refer to the baseline calibration for R , and Y . The grey solid lines
stand for 2 and the grey dashed lines denote 2:5. For the light grey squared solid lines it holds that Y 0:25 and the light grey squared dashed lines
stand for Y 0:5.

Fig. 4 summarizes the results.22 Starting from the baseline scenario, we observe a sharp decline in the persistence and
volatility of real GDP and consumer price inflation when the real house price coefficient, q , rises. This is because the central
bank becomes more restrictive in the early stage of the housing boom. Thereby, it detracts the sources that lead to a
sustained boom. A more restrictive monetary policy subdues demand for nondurable goods and housing investment, which,
in turn, lowers the rise in the real house price. As house prices are less volatile, swings in beliefs about future real house
prices are less likely to occur. Agents simply stick to the fundamental forecasting rule when they form their expectations on
future real house prices, which stabilizes house prices and the broader economy in a self-reinforcing fashion. In sum, by
reacting to house prices the central bank is able to prevent sustained waves of optimism and pessimism drive house prices
and thus real GDP and consumer price inflation.
Finally, to give the previous analysis a more meaningful role in terms of monetary policy evaluation we summarize the
evidence by comparing the monetary policy rules against a prespecified objective function based on the assumption that
the ultimate goal of monetary policy is to reduce real GDP and consumer price variability. The objective function can be
written as
Loss s2 Y^ t 1s2 C;t ;

55

where the parameter governs the policymakers' relative preferences. We choose to set 0:5 such that policymakers
attach an equal weight to minimizing output and consumer price volatility.

22
For the BE model we report median values obtained by simulating the model 1000 times, each time over 800 periods. For the RE model we report
the theoretical moments.

P. Bofinger et al. / Journal of Economic Dynamics & Control 37 (2013) 28622881

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Fig. 5. Augmented Taylor rule: full-fledged BE vs. RE model. Note: the black solid lines refer to the baseline calibration for R , and Y . The grey solid lines
stand for 2 and the grey dashed lines denote 2:5. For the light grey squared solid lines it holds that Y 0:25 and the light grey squared dashed lines
stand for Y 0:5.

Fig. 6. Impulse responses of the full-fledged BE and the RE model with a real house price-augmented Taylor rule to a monetary policy shock of 25 basis
points. Note: The x-axis is in quarters. The y-axis is measured in percent. The dashed lines are the impulse responses of the RE model. The solid lines
represent the median impulse responses of the BE model and the shaded areas stand for the 90% confidence intervals.

Fig. 5 underlines the highly non-linear features of the BE model. As soon as the real house price coefficient reaches a
critical threshold, the value of the central bank's loss decreases sharply. Moreover, the figure illustrates that the stabilizing
effect of a real house price-augmented Taylor rule is independent of whether policymakers attach a higher weight to
consumer price inflation. Even if the Taylor rule coefficient on consumer price inflation is 2:5, the monetary authority
can only achieve stability if it sets interest rates in response to house prices. In comparison, the stabilizing effect of a house
price-augmented Taylor rule is less pronounced when the reaction coefficient on the output gap is high. This is because

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a strong reaction to output variability drives the beliefs of agents regarding future consumption levels toward the steady
state. However, given the impact of swings in beliefs on future real house prices on the broader economy, the policymakers
only performs well in terms of minimizing its loss function by setting interest rates in response to real house price
movements.23 Most importantly, the difference in policy implications to be drawn from the RE counterpart model is striking.
The standard DSGE framework predicts that a stronger response to real house prices might not be a promising strategy.
Especially in cases in which policymakers strongly react to real GDP and consumer prices, the beneficial impact of
augmenting the Taylor rule with a real house price component is underestimated compared to the outcome in the BE model.
As booms and bust periods in the RE model considered merely represent macroeconomic fundamentals, and hence waves of
optimism and pessimism driving real house prices and in turn the overall economy do not occur, there is no obvious need
for a real house price-augmented Taylor rule.
Another means by which we can motivate the modification of the Taylor rule in our model can be illustrated through
impulse response analysis. In Fig. 6, we compute the impulse responses of the full-fledged BE model and the RE model for
the real house price-augmented Taylor rule. We choose to set q 2.
The results are clear. In the case of a standard Taylor rule the effects of an expansionary monetary policy shock are
dominated by non-linearities which makes the timing of the monetary policy shock important. However, the effects of a
monetary policy shock are highly predictive when the central bank sets interest rates in accordance with real house prices.
With a higher sensitivity of interest rates to real house prices, the scope in which endogenous and self-fulfilling waves of
optimism and pessimism can arise is limited. Fig. 6 also illustrates the success of a real house price-augmented Taylor rule in
terms of stabilizing the economy. By applying a standard Taylor rule, monetary policy is found to be accommodative at
the early stage of the boom in house prices and output as consumer price inflation is relatively stable. However, when the
central bank sets interest rates in accordance with real house prices, interest rates quickly revert back to the steady state
reducing the persistence and volatility of the business cycle.

8. Conclusion
In this paper, we incorporate heuristics into an otherwise standard DSGE model that captures important features of
housing to provide qualitatively insights into how monetary policy actions affect the housing market and in turn the overall
economy when behavioral mechanisms play a role. That is, we drop the assumption of rational expectations in an otherwise
standard model and alternatively assume that agents use heuristics to form expectations. As a key contribution we succeed
to implement notions of non-linearities into a DSGE model, a feature that is missing in the standard approach.
Key to our approach is that agents form heterogeneous and systematically biased expectations. In particular, we assume
that agents choose between an optimistic and a pessimistic rule (heuristic) to forecast future real house prices and base
their choice on the relative forecast performance of the rules. In a full-fledged BE model in which all behavioral expectations
operators are at play we discuss the propagation mechanisms of monetary policy. We find that monetary policy triggers
endogenous and self-fulfilling waves of optimism and pessimism that drive real house prices and in turn the broader
economy. By means of impulse response analysis we compare our BE model to the standard RE model. Three important
findings prevail. First, in the BE model the impact of a monetary policy shock on real house prices is surrounded by
uncertainty. Second, the dynamics in the BE model exhibit much higher persistence than in the RE model. This relatively
high persistence in the BE model is due to the gradual change in the forecasting rules of agents. Third, we find that in the BE
model consumer price inflation is relatively stable at the early stage of the boom. Thus, standard monetary policy does not
counteract the boom in house prices and the broader economy by raising interest rates.
Finally, we suggest that in our BE model there is a meaningful role for a real house price-augmented Taylor rule as it
helps to rule out that monetary policy itself becomes a major source of economic disturbance. As behavioral mechanisms
are not present in the standard RE model we find that the merits of augmenting the Taylor rule with a real house price
component are underestimated in this framework.

Acknowledgement
We thank three anonymous referees and the Editor, Cars Hommes, for helpful comments and suggestions. We also thank
participants of the EEA 2011 in Malaga, the German Economic Association 2011 in Frankfurt, the DSGE and beyond expanding the paradigm in monetary research? conference of the The National Bank of Poland in Warsaw, and the
conference After(?) the Storm: Lessons from the Great Recession of the Rimini Centre for Economic Analysis, Rimini for
their suggestions on earlier versions of the paper.

23

Note that even in the case in which policymakers set a high weight on output, the loss halves if q 1.

P. Bofinger et al. / Journal of Economic Dynamics & Control 37 (2013) 28622881

2879

Appendix A. Steady state


Prices are given as constant markups over nominal marginal costs and read P j j =j 1W j , j C; H. We assume that
markups are equal across sectors (C H ), which implies that the steady state real house price is q 1. As for the steady
state interest rate, it holds true that R 1=.
The savers' total supply of labor is




1
1 

1
1
1
 L L
0;
A:1

1h
~ R1b~ and C =H 1=1h11 . The total supply of labor is distributed
where =11= L
across sectors according to L C 1H L and L H H L. The savers' steady state consumption of nondurable goods is given by



1
1 
C
L :
A:2

1h
1

The savers' steady state housing stock is H C and residential investment is defined by HI H.
The borrowers' total supply of labor is
"
!#1=1

1
R111
~L
1
;
1h
~

A:3

~
~ C~ =H~ 1=1h11~ 1.
where
Total labor supply is distributed across sectors according to
~L C 1H L~ and L~ H H L~ . The borrowers consumption of nondurable goods is given by



1
1 ~ 
A:4
C~
L :

1h
~
The borrowers' housing stock is H~ C~
~
~
are b 11H .

1

~ H~ . The borrowers' debt holdings


and residential investment is defined by HI

Technologies are Y j L j , j C; H, where total labor supply in each sector is given by L j L~ j 1L j . The steady
tot

tot

state debt market equilibrium is given by b =1b~ . Total consumption of nondurable goods is Y C C~ 1C and
~ 1HI. Real GDP equals Y Y C Y H .
total residential investment is Y H HI
Appendix B. The formation of expectations on future consumption of nondurable goods
The optimistic, respectively, pessimistic rule that savers (X C) and borrowers (X C~ ) use to forecast future nondurable
goods consumption is given by
^
Eopt
t X t1

dt
2

and

dt
^
Epes
;
t X t1 
2

B:1

X
X
where the absolute divergence in beliefs, dt , follows dt d d sX^ t . The MSFEs of the two rules are given by

X^ 2
U Xopt;t k X^ tk Eopt
tk1 tk

B:2

k1

and

X^ 2 :
U Xpes;t k X^ tk Epes
tk1 tk

B:3

k1

The fundamental forecasting rule reads


^
Efun
t X t1 0

B:4

and the MSFE of the fundamental rule is defined by


1

X^ 2 :
U Xfun;t k X^ tk Efun
tk1 tk

B:5

k1

The corresponding fractions of optimists, pessimists and fundamentalists then evolves as


Xopt;t

Xpes;t

expU Xopt;t
expU Xopt;t expU Xpes;t expU Xfun;t
expU Xpes;t
expU Xopt;t

expU Xpes;t expU Xfun;t

B:6

B:7

2880

P. Bofinger et al. / Journal of Economic Dynamics & Control 37 (2013) 28622881

and

Xfun;t

expU Xfun;t
expU Xopt;t

expU Xpes;t expU Xfun;t

1Xopt;t Xpes;t :

B:8

Appendix C. Sensitivity analysis


In this section, we present our calibration strategy for the parameters governing the formation of expectations and
present some sensitivity analysis following De Grauwe (2011).
For the calibration of the behavioral parameters we proceed as follows. As in the simplified BE model, we set Et C^ t1 0,
^
Et C~ t1 0 and Et C;t1 0 and proceed by computing the correlation coefficient of qopt;t and q^ t as a function of the
parameters that govern the formation of beliefs about future real house prices. We choose to pick parameter values such
that the correlation coefficient is maximized. We then adopt these parameter values for the formation of expectations on
future consumption of nondurable goods and consumer price inflation.
In Fig. C1, we present some sensitivity analysis by reporting how the correlation coefficient between house price
optimists and actual real house prices as well as the standard deviation of real house prices depend on the set of behavioral
parameters, namely the intensity of choice, , the parameters describing the divergence in beliefs, d and d , and the
memory parameter, . In particular, we report the median correlation coefficient and standard deviation (obtained by
simulating the model 1000 times, each time over 800 periods) as a function of these parameters relative to the baseline
calibration.
A key parameter for the formation of expectations on future real house prices is the intensity of choice. The left upper
panel illustrates that even for small values of (a minimum degree of rationality) there exists a high correlation between the
fraction of real house price optimists and actual real house prices. In the limiting case of 0, the correlation coefficient
equals zero. As is apparent from the left lower panel, if 0, the standard deviation of house prices is lowest. This is because
in such an economy there is no systematic feedback mechanism between the swings in beliefs on future real house prices
and actual real house prices. The second and third upper panel shows that the correlation between the fraction of real house
price optimists and actual real house prices is relatively stable for the parameter values considered for d and d .
Remarkably, the emergence of animal spirits that drive real house prices does not critically hinge on the assumption that
the divergence of beliefs is a function of the volatility of real house prices. The correlation coefficient between the fraction of
real house price optimists and actual real house prices only slightly decreases if d 4 2. This result is obtained because a high
value of d increases the penalty when agents make wrong forecasts. As a consequence, agents change beliefs more quickly
and waves of optimism and pessimism that drive real house prices are less likely to occur. In contrast, the standard deviation
of real house prices increases when d is increased. The clear positive relation is achieved due to the positive feedback
mechanisms between the divergence of beliefs on future house prices and actual house price volatility. This positive
feedback mechanism is less clear cut for d . The standard deviation of house prices reaches its maximum if d 2. The right
upper panel illustrates that for a minimum degree of forgetfulness a high correlation between qopt;t and q^ t occurs. Note that

Fig. C1. Real house prices and animal spirits.

P. Bofinger et al. / Journal of Economic Dynamics & Control 37 (2013) 28622881

2881

if decreases, the memory of agents decreases and agents will give more weight to recent observations. Only for a very long
memory (when approaches 1) the link between the way agents form expectations on future real house prices and actual
real house price becomes less important. Similarly, the standard deviation of real house prices decreases if the memory of
agents increases. A long memory of agents implies that destabilizing swings in beliefs of agents will less likely occur.
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