Consumption, Housing Collateral and The Canadian Business Cycle

Consumption, housing collateral and the
Canadian business cycle

Ian Christensen and Paul Corrigan Bank of Canada
Caterina Mendicino Banco de Portugal and European
Central Bank
Shin-Ichi Nishiyama Graduate School of Economics and
Management, Tohoku University
Abstract. How important are collateral constraints for reproducing salient features of
the data? To address this question, we estimate two nested versions of a New Keynesian
model: one with collateralized household debt and the frictionless version of the same
model. Both versions of the model are fit to Canadian data using Bayesian methods. We
argue that the presence of collateral constraints improves the performance of the model in
terms of overall goodness of fit. Housing collateral helps to generate a positive correlation
between consumption and house prices. Moreover, housing collateral induced spillovers
boosted consumption growth during the housing market boom-bust cycles of the late
1980s and early 2000s.
Résumé. Consommation, bien immobilier comme garantie et le cycle d’affaires canadien.

Quelle est l’importance des contraintes collatérales dans la reproduction de caractéristiques
pertinentes des données? On attaque la question en calibrant deux versions imbriquées
d’un modèle de type nouveau-keynésien : l’un avec garantie collatérale immobilière pour la
dette des ménages et l’autre une version sans friction du même modèle. Les deux versions
sont appliquées aux données canadiennes à l’aide de méthodes bayésiennes. On suggère
que les contraintes de garantie améliorent la performance du modèle en termes de qualité
d’ajustement. La garantie collatérale immobilière engendre une corrélation positive entre
la consommation et le prix des maisons. De plus, cette contrainte collatérale déclenche
une croissance de la consommation engendrée par les effets de débordements au long du
sentier de croissance et décroissance des cycles de la fin des années 80 et début 2000.
JEL classification: E32, E44, G12, O40
We are grateful to Matteo Iacoviello, Fabio Canova and Giorgio Primiceri for useful feedback
on this project. We also wish to thank Allan Crawford, Stephen Murchison, Hajime Tomura
and workshop participants at the Bank of Canada, the 2007 Midwest Macro Meetings, the 2007
Computation in Economics and Finance Meeting and the 2007 North American Summer
Meeting of the Econometric Society for comments and suggestions. David Mandelzys, Linxin
Zhang and Alexander James provided excellent research assistance. Any remaining errors are
ours. This paper was started when Caterina Mendicino and Shin-Ichi Nishiyama were senior
analysts at the Bank of Canada.
Corresponding author: Caterina Mendicino, caterina.mendicino@gmail.com
Canadian Journal of Economics / Revue canadienne d’économique, Vol. 49, No. 1

February 2016. Printed in Canada / Février 2016. Imprimé au Canada
0008–4085 / 16 / 207–236 / © Canadian Economics Association

208 I. Christensen, C. Mendicino and S.-I. Nishiyama
1. Introduction
Since Kiyotaki and Moore’s (1997) theoretical work, collateralized debt has be-
come a popular feature of macroeconomic models. Recent papers document the
role of collateral constraints for business cycle fluctuations. In estimated mod-
els of the US business cycle, collateral effects help the model to reproduce the
positive response of spending to a house price shock (see Iacoviello 2005) and
generate sizeable housing market spillovers (Iacoviello and Neri 2010). Looser
credit constraints at the household level contributed to the decline in macroe-
conomic volatility experienced in the US in the 1980s and 1990s (Campbell and
Hercowitz 2004). The collateral mechanism has also important implications for
the international transmission of shocks (Iacoviello and Minetti 2007). Collateral
constraints amplify and propagate macroeconomic fluctuations also through the
joint dynamics of land prices and business investment (Liu et al. 2013).
This paper revisits the role of collateral constraints by quantifying their aggre-
gate implications in a model of the Canadian business cycle. We argue that the
collateral mechanism is not only qualitatively but also quantitatively important
for consumption and house price dynamics. We develop this argument by com-
paring the quantitative performance of two nested models: a model with collater-
alized household debt and the frictionless version of the same model. We pursue
a multivariate approach and estimate the entire structure of the model using the
full-information likelihood-based approach. The full-information approach op-
timally adjusts the estimation of the parameters of the models to match the data.
Thus, we give a fair chance to both versions of the model to perform equally well in
matching the data.1 Following the DSGE literature, we estimate the two versions
of the model using Bayesian methods.2 We conduct Bayesian inference and use
posterior probabilities to assess the adequacy of the two alternative modelling
frameworks. We complement previous findings by quantitatively assessing the
role of collateral constraints through model comparison rather than just through
sensitivity analysis as is common in the literature. Further, we also contribute to
the large literature on estimated DSGE models of the Canadian economy.3 In
1 Rather than limiting the analysis to the estimation of single equations derived by the two
alternative specifications of the model, we prefer to compare the models on the bases of a
full-information approach. Model comparisons based on the estimations of single equations,
such as Euler equations or housing demand equations, would test the performance of the model
in only one particular dimension.
2 See, among others, Smets and Wouters (2003, 2007), Iacoviello and Neri (2010), Justiniano et al.
(2010) and Covas and Zhang (2010).
3 Closed-economy DSGE models of the Canadian economy have been estimated by, among
others, Dib (2003, 2006), Dib, Gammoudi et al. (2008), Atta-Mensah and Dib, (2008) and
Covas and Zhang (2010). For estimated small open economy models of the Canadian economy,
see Ambler et al. (2004) and Justiniano and Preston (2010a, 2010b) for standard one-sector
models; see Ortega and Nooman (2006) for a two-sector small open economy model model; see
Dib (2008) for a multi-sector model and Dib, Mendicino et al. (2008) for a multi-sector model
with credit frictions.
Housing collateral and the business cycle 209
fact, this paper represents the first attempt to quantify the role of credit frictions
at the household level over the business cycle in Canada.4
The analysis proceeds in three steps. First, we introduce the collateral con-
straint mechanism at the household sector into a New Keynesian small open
economy framework. In order to match a broad set of features observed in the
data, the model economy includes a set of nominal and real rigidities that have
been shown useful to match the data (Christiano et al. 2005; Smets and Wouters
2007). At the core of the model is the borrowers–lenders setup developed by
Kiyotaki and Moore (1997). The model features two types of households that
differ in terms of the rate at which they discount the future. In equilibrium, one
type of households borrows, whereas the other lends. Credit constraints arise
because lenders cannot force borrowers to repay. Thus, houses are used as loan
collateral. Houses are elastically supplied. Foreign savers also supply funds to
the domestic economy. Second, to quantify the role of the collateral constraint
mechanism, we fit the model to Canadian data. In particular, we estimate two
versions of the model, one nested in the other. In the benchmark model, housing
collateral value can have an impact on aggregate consumption through collateral
constraints and in the alternative specification this channel is not allowed to op-
erate. Third, we assess the importance of the model’s collateral effect in its ability
to capture key features of consumption and house price data at business cycle
frequencies.
This paper provides several insightful results. We find statistical evidence
suggesting that collateral links between the housing market and the rest of the
economy are quantitatively important. The model with collateral constraints out-
performs the model without them in terms of overall goodness of fit. Indeed,
collateralized household debt helps to generate the positive correlation between
consumption and house prices observed in the data. As the recent experience
in many OECD countries has shown, house prices can fluctuate considerably
over time, making it important to understand how changing house prices influ-
ence consumption behaviour.5 In our general equilibrium framework, there is a
variety of aggregate disturbances, including shocks related to productivity, which
can drive both consumption and house prices.6 Our results highlight that there
are important differences across models in the response of consumption to a par-
ticular shock. In particular, significant differences are found in the transmission
4 For models of the Canadian economy with credit frictions at the firm level, see Dib, Mendicino
et al. (2008), Covas and Zhang (2010) and Zhang (2011).
5 See Hubrich et al. (2013) for evidence on macro-financial linkages in OECD countries.
6 Consumption expenditures and house prices co-move over the business cycle. This positive
correlation can be found in macroeconomic time-series estimates for a variety of countries (Case
et al. 2005) including Canada (Pichette and Tremblay 2003). Micro data studies also show the
important link between consumption and house prices. Campbell and Cocco (2007) find that
consumption expenditures and house prices are more strongly related among household
groupings that are likely to face financial constraints. Attanasio et al. (2005) argue that the
co-movement of consumption and house prices represents their responses to some other
common factor, such as a productivity shock.
of housing demand shocks. In the model without collateral constraints, a posi-

tive shock to housing demand shift the households’ housing demand upwards.
House prices rise and households shift expenditures from consumption goods to
houses. Thus, the frictionless model predicts a negative co-movement between
house prices and the consumption of goods. In the model in which borrowers
are constrained by the value of their housing assets, rising house prices can also
improve the debt capacity of borrowers. The expansion of households’ credit al-
lows them to also increase consumption expenditures. Thus, a rise in the value
of housing collateral generates a positive response of consumption to a housing
demand shock.
Further, our estimates suggest that housing market shocks are an important
source of fluctuations in macroeconomic variables in Canada. In particular, hous-
ing demand shocks are the largest contributors to fluctuations in house prices
and also account for a non-negligible fraction of the variance in GDP and con-
sumption. Further, we document that the collateral effect contributes materially
to consumption dynamics during macroeconomic booms. Housing collateral-
induced spillovers accounted for a large share of consumption growth during the
housing boom of the late 1980s and the sharp declines in consumption growth in
the early 1990s. Collateral effects also boosted consumption growth in the early
part of the early 2000 housing boom.
The rest of the paper is organized as follows. We present the details of the
model in section 2. Section 3 describes the estimation strategy and the data.
Section 4 outlines the empirical results. Section 5 compares the two versions
of the model in terms of overall goodness of fit, transmission mechanism and
business cycle properties. Section 6 explores the implications of different shocks
over the cycle and quantifies the effects of collateral requirements over history.
Section 7 concludes.
2. Model
The economy is populated by two types of households of unit mass: patient

(denoted by i = 1) and impatient (denoted by i = 2). As in Kyiotaki and Moore
(1997), patient households have a higher propensity to save, i.e., ¯1 > ¯2 . So, in
equilibrium, they supply loans to impatient agents. To prevent borrowing from
growing without limit, we assume that borrowers face credit constraints tied to
the expected future value of collateral.
The economy is also populated by perfectly competitive intermediate-good-
producing firms, retailers that operate in a monopolistically competitive market,
capital and house producers and a monetary authority that follows a standard
Taylor-type interest rate rule. The model includes a set of nominal and real rigidi-
ties as in Smets and Wouters (2007) and Christiano et al. (2005) augmented by
open economy features that have been shown useful to match the data (e.g.,
Adolfson et al. 2007; Justiniano and Preston 2010a, 2010; Dib 2008).
2.1. Households
Households supply labour and derive utility from consumption, ci,t , and housing
services, hi,t :
∞

t L,t ´
maxE0 ¯i b,t ln(ci,t − bCi,t−1 ) + jt lnhi,t − Li,t , (1)
t=0 ´
where i = {1, 2} denotes the two types of households, bCi,t−1 represents external
habits in aggregate consumption, b,t is a shock to the discount rate that affects
the intertemporal substitution of households, ji,t is a shock to the preference for
housing services and L,t is a shock to the disutility of labour. As common in the
literature, housing services are assumed to be proportional to the stock of houses
held by the household.7
Lenders. Patient households accumulate properties for housing purposes, h1,t ,
supply loans to impatient households, b1,t , buy foreign bonds, bÅt , invest in phys-
ical capital, kt , that they rent to the final-good-producing firms at the rate Rtk
and receive dividends, Ft . Thus, they maximize their expected utility subject to
the following budget constraint:

Rt−1 b1,t−1
c1,t + qh,t (h1,t − (1 − ±h )h1,t−1 ) + qk,t (kt − (1 − ±h )kt−1 ) + − b1,t
¼t
Å
Rt−1 &t−1 bÅt−1
+ · · · + st − bÅt = w1,t L1,t + Rtk kt−1 + Ft + Tt , (2)
¼tÅ
where ¼t = Pt =Pt−1 is the gross inflation rate, qh,t is the price of housing, qk,t is
the price of capital, w1,t are real wages and st the real exchange rate. The stock of
housing and capital depreciate at a rates ±h and ±h , respectively. All the variables,
except for the gross nominal interest rates on domestic and foreign bonds, Rt , and
RtÅ , are expressed in real terms. The return on foreign debt depends on a country
specific risk premium & that is required for the model to feature a stationary
distribution.8 Following Adolfson et al. (2007) we assume that the risk premium,
&t , depends on the ratio of net foreign debt to domestic output and the expected
exchange rate:
st bÅt Et st+1 st
&t = exp Á + Ás − 1 + s,t . (3)
Ptd Yt st st−1
The inclusion of the expected exchange rate in the specification of the risk pre-
mium is motivated by empirical findings of a strong negative correlation between
the risk premium and the expected depreciation.9 The demand for foreign funds
combined with the demand function for domestic loanable funds, implies an
uncovered interest parity condition, which in log-linearized form obeys:
r̂t − r̂Åt = (1 + Ás )Et 1st+1 + Ás 1st + Á, (4)
where rt = Rt − Et ¼t+1 .
7 See, for example Iacoviello (2005), Iacoviello and Neri (2010) and Liu et al. (2013).
8 See Schmitt-Grohe and Uribe (2003) for further details.
9 See Duarte and Stockman (2005).
Borrowers. Impatient households maximize their stream of expected future utility

subject to the following budget constraint:
Rt−1 b2,t−1
c2,t + qh,t (h2,t − (1 − ±h )h2,t−1 ) = w2,t L2,t − + b2,t (5)
¼t
and a borrowing constraint:
qh,t+1 ¼t+1 h2t
b2t mEt . (6)
Rt
Borrowing is limited to a fraction of the value of borrowers housing stock, where,
(1 − m) represents the cost that lenders have to pay in order to repossess the asset
in case of default. Thus, for this group of agents, the marginal benefit of holding
one extra unit of housing also takes into account the marginal benefit of being
allowed to borrow more. It is possible to show that, in the present framework,
impatient households borrow up to the maximum in the neighbourhood of the
deterministic steady state.10 Impatient households do not have direct access to
foreign lending.
Wage setting. Finally, as in Erceg et al. (2000), we assume that each household
z ∈ (0, 1) of type i ∈ {1, 2} is a monopoly supplier of differentiated labour services.
Both household types face the same degree of wage stickiness. Households set
nominal wages in staggered contracts, where (1 − μw ) is the probability of chang-
ing the wage in any given period, as in Calvo (1983). Those households who do
not reoptimize their wage, index it to the steady-state rate of inflation. As all
households of each type behave in the same way, the nominal wage index, Wi,t ,
evolves over time according to the following recursive equation:
1
Wi,t = (μw (Wi,t−1 )1−w + (1 − μw )(W̃ i,t )1−w ) 1−w . (7)
2.2. Intermediate good production

Intermediate goods, Ytd,int, are produced in a perfectly competitive market by the
following technology:

1−°
® °
Ytd,int = zt L1,t 1−®
L2,t kt−1 , (8)
where zt is an aggregate productivity shock, k is rented capital and L1 and L2
are labour supplied by patient and impatient agents, respectively. Intermediate
domestic goods are sold at the competitive price mctd, i.e., at domestic marginal
cost. As in Iacoviello (2005) and Iacoviello and Neri (2010), we assume that
different labour types are complements.11 Under this formulation the parameter
® is a measure of the labour income share of the unconstrained households. First
order conditions for the intermediate-good-producing firm are standard.
10 Consider the
Euler equation of the impatient household evaluated at the deterministic steady
state ¹2 = 1 − ¯¯2¼ Uc2 > 0, where ¹2 is the Lagrange multiplier associated to the borrowing
1
constraint.
11 The primary motivation for this assumption is to obtain a closed-form solution for the steady
state of the model.
2.3. Final good

We model price rigidities following the New Keynesian literature. For complete-
ness, in the following, we report a brief description of the problem.
2.3.1. Wholesale goods

Domestic goods. Branding firms of domestic goods buy the homogeneous inter-
mediate inputs, Y d,int, at price mctd, and differentiate it slightly into Ytd (z). Inter-
mediate goods of each brand, Ytd (z), are imperfect substitutes in the production
of the composite domestic good and are sold at price P̃ td (z) in a monopolistically
competitive manner, as in Calvo (1983). At time t, each branding firm is allowed
to revise its price with probability (1 − μd ). Firms maximize the expected present
d
value of their real dividends setting P̃ t (z):
d

∞
k P̃ t (z) d d d
μd Et Uc1, t+k − mct+k Yt+k (z ) = 0. (9)
k=0 Pt+k
d
−p, t
P̃ (z)
The demand curve for each good obeys Ytd (z) = t d Ytd, where the price
Pt
elasticity p is subject to a markup shock. Each domestic brand is then aggregated
1 p, t −1 p, t
−1
into a domestic wholesale good, Y d, such that Ytd = (Ytd (zd )) p,t dzd p,t .
o
This implies that the price of the domestic intermediate good, Ptd , is given by
1 1
1−p,t
Ptd = (Ptd (zd ))1−p, t dzd . Thus, it is possible to show that the price index
o
of domestic wholesale goods evolves as follows:
1
d 1−p,t
Ptd = (μd (Pt−1
d
)1−p, t + (1 − μd )(P̃ t )1−p, t ) . (10)
Foreign goods. Branding firms of imported goods buy a homogeneous intermedi-
ate foreign good at price PtÅ to produce a differentiated good Ytm (zm ). Imported
intermediate goods are imperfect substitutes in the production of the composite
Å Å
1 p, t −1 Åp, t
Å
imported good Yt , such that Yt = (Yt (z ))
m m m m p,t dz m p,t −1
, where Åp,t is a
o
markup shock. At any given time, importers are allowed to revise the price of
their intermediate good with probability (1 − μm ). As in the case of domestic
goods, the price index of imported wholesale goods evolves as follows:
1

1−Åp,t
1−Åp, t m Å
Ptm = μm (Pt−1
m
) + (1 − μm )(P̃ t )1−p, t . (11)
2.3.2. Retailers
Finally, retailers combine domestic and imported goods, Y d and Y m, into a
final good Y. Retailers operate in a perfectly competitive market using a CES
production function:
Á
1
Á−1
Á 1 Á−1 Á−1
Yt = 1−! Á Ytd +! Á m
Yt Á , (12)
where ! > 0 is the weight on imported goods in the final domestic goods basket and
Á > 0 is the elasticity of substitution between domestic and imported intermediate
goods. Cost minimization entails the following demand curves for Y d and Y m :
−Á m −Á
Ptd P
d
Yt = 1 − ! Yt , Yt = ! t
m
Yt + m,t , (13)
Pt Pt
where m,t is a shock to the demand of imported goods.

Given the Armington (or CES) aggregator for domestic and foreign quantities,
cost minimization leads to the following definition of the aggregate price index:
1
Pt = [ 1 − ! (Ptd )1−Á + !(Ptm )1−Á ] 1−Á. (14)
2.4. Capital producers

Capital producers use a fraction of final goods purchased from retailers as in-
vestment goods, Ik,t , combine it with the existing capital stock and produce new
capital goods.12 As in Greenwood et al. (2000), we assume that the technology
is subject to an investment-specific shock, Ak,t , that is a shock to the marginal

efficiency of investment.
Capital production is also subject to an adjustment cost

specified as Ã2k I k, t − 1 2 Ik,t , where Ãk governs the slope of the capital pro-
I
k, t−1
ducers adjustment cost function. From the profit maximization it is possible to
derive the supply of capital:
2
k 1 Ãk Ik,t Ik,t Ik,t
qt = 1+ − 1 + Ãk −1
Ak,t 2 Ik,t−1 Ik,t−1 Ik,t−1
2
³t+1 Ãk Ik,t+1 Ik,t+1
− Et −1 , (15)
³t Ak,t+1 Ik,t Ik,t
where qtk is the capital price and ³t =¯1 Uc1, t+1

Uc1, t is the stochastic discount factor of
the economy. In the absence of investment adjustment costs, the price of capital
equals A1 .
k, t
2.5. Housing producers

Housing producers combine final goods with the existing housing stock and

produce new units of installed houses.
Housing production is also subject to an

Ãh Ih, t
adjustment cost specified as 2± − ± h
2h
t−1 . For a similar formulation see
h ht−1
Aoki et al. (2002). Capital producers choose the level of Ih,t that maximizes their
profits:
12 Here we follow, among others, Bernanke et al. (1999), Christiano et al. (2003) and Christensen
and Dib (2008).
2
1 Ãh Ih,t
max qth Ih,t − Ih,t + − ±h ht−1 , (16)
Ih, t Ah,t 2±h ht−1
where Ah,t is housing-specific technology shock, i.e., a shock to the marginal
efficiency of producing housing. New housing capital goods are sold at price qth :

h 1 Ãh Ih,t
qt = 1+ − ±h . (17)
Ah,t 2±h ht−1
This equation is similar to the Tobin’s q relationship for investment, (eq 13),
in which the marginal cost of a unit of housing is related the marginal cost of
adjusting the housing stock. Note that a positive shock to the housing specific
technology will reduce the price of installed housing.
2.6. Monetary policy

The monetary authority follows a Taylor-type interest rate rule:
+ MP,t .
R̂t = ½R R̂t−1 + (1 − ½R )½¼ (¼ˆ t − ¼ˆ Åt ) + (1 − ½R )½Y GDP (18)
Thus, the nominal interest rate is adjusted in response to deviations of inflation
We
from its target, ¼ˆ Åt , and deviations of GDP from its steady-state value, GDP.
also allow for interest-rate smoothing behaviour. As in Smets and Wouters (2007)
and Adolfson et al. (2007), the inflation target of the central bank, is assumed
to be time varying and is subject to an AR(1) shock, whereas MP,t is an i.i.d.
monetary policy shock.
2.7. Market clearing conditions

Domestic output Yt , can be consumed, invested or exported:
Yt = Ct + qk,t Itk + qh,t Ith + Ytx , (19)
where Ct = c1,t + c2,t , Ih,t = ht − (1 − ±h )ht−1 , Ik,t = kt − (1 − ±k )kt−1 and Ytx is the
demand for the domestic economy’s exports.
The domestic loan market condition implies that total borrowed funds are
equal to funds lent out by patient households:
b2,t = −b1,t . (20)
The aggregate stock of housing is such that:
ht = h1,t + h2,t . (21)
The trade balance equals economy-wide net saving:
f
Rt &t−1 f f
Ytx − st Ytm = st f
bt−1 − bt . (22)
¼t
Finally, real GDP is defined as:
GDPt = Ct + qk Itk + qh Ith + Ytx − st Ytm . (23)
As in Iacoviello and Neri (2010) and Davis and Heathcote (2005), we define GDP
at constant prices and set the relative prices qh, qk, s equal to their steady-state
values.
2.8. Rest of the World

We consider Canada to be a small open economy. Thus, domestic developments
do not affect the rest of the world economy. In contrast, the foreign economy’s
dynamics have an impact on the Canadian economy. Since the US is the main
trade and financial partner for the Canadian economy, we model the foreign block
along the lines of the Terms-of-Trade Economic Model (ToTEM) developed by
the Bank of Canada. By analogy with the import demand function of the local
x
economy, the demand for the domestic economy’s exports, Ŷ t , is described by:
x g x
Ŷ t = Ŷ t − ÁP̂ t + ex,t , (24)
x Px
where P̂ t = Ptg
is the real price of local brands in the global economy, ex,t is an
t g
export demand shock and Ŷ t is the foreign demand which is pinned down by
the export data We also assume that foreign export prices evolve in a way that
is analogous to our assumption for domestic import prices. Thus, the linearized
equation for the foreign price of imports from Canada obeys:
(1 − μx )(1 − ¯μx ) x
¼ˆ xt − ¯f E ¼ˆ xt+1 = (−ŝt − P̂ t ), (25)
μx
Px
where ¼tx ≡ Pxt and μx is the probability that the price of a local brand will remain
t−1
sticky in the global economy in a given period.
2.8.1. Shock processes

In the model, there are 11 shocks Âj,t = {b,t , jt , s,t , zt , Ah,t , Ak,t , IO,t , L,t , ex,t ,
m,t , p,t } that follow an AR(1) process:
ln(Âj,t ) = ½Âj ln(Âj,t−1 ) + "Âjt , "Âj, t iid N(0, ¾"Âj ), 0 < ½Âj < 1, (26)
where ½Âj is the persistence parameter and "Âj, t is i.i.d. white noise process with
mean zero and variance ¾&2 . In contrast, the monetary policy shock, ,MP,t , is a
zero-mean i.i.d. shock with variance ¾MP .
3. Data and model estimation
The vector of structural parameters of the model, 3, describing preferences,

technology, the monetary policy rule and the shocks is estimated using Bayesian
techniques. First, for given parameter values we solve the model using standard
first-order approximation techniques. Then, we use the Kalman filter to compute
the likelihood L(0t |3) for the given sample of data 0t , as in Hamilton (1994).
We use some informative priors, '(3), in order to downweight regions of the
parameter space that are widely accepted to be uninteresting. Using Bayes’s rule,
the posterior distribution can be written as the product of the likelihood function
of the data given the parameters, L(0t |3), and the prior, '(3):
P(3|0t ) L(0t |3)'(3) (27)
We start by estimating the mode of the posterior distribution by maximizing the
log posterior function. Second, we obtain a random draw of size 500,000 from the
posterior distribution using the random-walk Metropolis–Hastings algorithm.
The posterior distribution of the parameters are then used to draw statistical
inference on the parameters themselves or functions of the parameters, such as
second moments.
3.1. The data

We estimate the model using Canadian data for consumption, capital investment,
residential investment, exports, imports, hours worked, real wages, real house
prices, short and long-term nominal interest rates, the real bilateral exchange
rate (with the United States) and the inflation rate. The availability of the house
price data and a desire to have a sample over which the conduct of monetary
policy and the statistical properties of inflation have been relatively stable restrict
us to considering data from 1981Q1 to 2007Q4. All of our series are taken at a
quarterly frequency. The real series are logged and linearly detrended to derive
the data used in estimation (figure 1).
All of our expenditure data is from the Canadian Income and Expenditure
Accounts published by Statistics Canada. Consumption is measured by real per-
sonal expenditure on consumer goods and services, while residential investment is
real residential structures investment. For capital investment we use real business
fixed investment (equipment and structures). The data for exports and imports
include both goods and services trade. Data on actual hours worked are taken
from the Labour Force Survey and wage data include wages, salaries and sup-
plementary labour income, taken from the Income and Expenditure Accounts.
Our measure of real house prices is the Multiple Listing Service existing house
sales price. This index measures the average sale price of all existing residential
dwellings sold in a given period.13 We calculate the real house price by deflating
this house price series using the CPI measure described below.
We use the Bank of Canada’s measure of “core” CPI inflation. This measure
of inflation in consumer prices excludes the effects of price changes from eight of
the most volatile components of the CPI (e.g., mortgage interest costs, vegetables
and gasoline) and changes in indirect taxes.14 The inflation rate is expressed
13 This series is highly correlated with an alternative index of resale housing prices from Royal
Lepage that measures the prices of houses with similar characteristics in different regions across
the country. For this reason we do not think that composition bias is important enough to affect
our results.
14 Unlike the US consumer price index, the Canadian CPI data do not include the cost of imputed
rents. Nonetheless, house prices do affect our measure of inflation through owned
accommodation prices, which include such costs as home insurance, house depreciation and
property taxes.
Consumption Residential investment Capital investment

0.15 0.4 0.4
0.1 0.2 0.2
0.05 0 0
0 –0.2 –0.2
–0.05 –0.4 –0.4

1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010 20 40 60 80 100 120
Imports
Exports Hours
0.4 0.4 0.1
0.2 0.2 0.05
0 0 0
–0.2 –0.2 –0.05
–0.4 –0.4 –0.1
1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010
Real wage Inflation Yield spread

0.1 0.03 0.02
0.05 0.02
0.01
0 0.01
0
–0.05 0
–0.1 –0.01 –0.01
1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010
Real exchange rate

0.4 House price
0.6
0.2 0.4
0 0.2
–0.2 0
–0.4 –0.2
1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010
FIGURE 1 Detrended data series used in estimation
as a quarterly rate. We subtract 0.5% (the Bank of Canada’s inflation target

expressed in quarterly rates) from this series before estimation. Though this is
not the full-sample mean, it has the advantage that the treatment of the data is
consistent with inflation being at the Bank of Canada’s target in the steady state.
In practice, the “inflation objective shock” will then account for the transition
from the higher inflation of the 1980s to the period in which the Bank of Canada
formally adopted inflation targeting. The real exchange rate is calculated as the
product of the nominal exchange rate (price of a US dollars in terms of Canadian
dollars) and the US CPI (excluding food and energy) divided by Canadian “core”
CPI.
The overnight rate, the interest rate at which major financial institutions bor-
row and lend one-day (or “overnight”) funds among themselves, is our measure
of the short-term nominal interest rate. We subtract the 10-year Government of
Canada bond rate from this short-term rate to obtain a measure of the yield
spread. We chose to use this term spread series rather than the overnight rate on
its own because the latter implies that real interest rates have been trending down
over our sample.15 This implies that stance of monetary policy was restrictive
throughout the 1980s and easy after the early 1990s, which is at odds with the
historical interpretation of events reported in Armour et al. (1996). In contrast,
the term spread appears to be more consistent with the historical record and also
similar to other measures of the stance of Canadian monetary policy described
in Fung and Yuan (1999).16
15 De Graeve et al. (2007) is another example of a medium-scale DSGE model estimated with yield
curve data (for the United States).
16 A detailed description of the data sources and plots of the detrended data are presented in the
technical appendix, available in the online version of this article.
3.2. Calibrated parameters

We set a number of parameters before estimation based on sample means or
previous studies. The calibrated parameters include the discount factors ¯1 , ¯2 ;
the weight on housing in the utility function j; factor share °; depreciation rates
±h , ±k ; the steady-state gross markups for all price-setting firms; and the household
loan-to-value ratio mh .
Regarding preferences, the housing preference parameter j is set to match the
ratio of personal sector residential housing (land plus structures in the National
Balance Sheet Accounts) to quarterly GDP, which for our sample period averages
about 6.9.17 We follow Iacoviello (2005) who draws from micro-studies of the
range of discount factors of consumers, in setting the discount factor of patient
agents ¯1 to 0.99 and the discount factor of impatient agents ¯2 to 0.95.18 The
patient agent’s discount factor implies a steady-state real interest rate of 4% on
an annual basis.
As for the loan-to-value ratio, over most of our sample, Canadian law required
mortgages in excess of 75% of the value of the property to be insured. In practice,
home buyers were able to obtain loans at considerably higher loan-to-value ratios
with insurance. The minimum downpayment required by insurers varied over
our sample, dropping from 10% to 5% in 1992 and to 0% in 2004. It returned
to 5% more recently. Thus, on average over our sample, loan-to-value ratios for
constrained households are likely to have fallen in the 0.75 to 0.95 range.19 With
no direct estimates for Canada, we set m = 0.80, slightly lower than the value
chosen by Iacoviello and Neri (2010), based on US data on new home buyers.
As a typical house has a much longer lifetime than a typical piece of equipment,
the housing depreciation rate, ±H, should be lower than ±k. The value of ±H
compatible with the housing investment to GDP ratio was 0.01, implying an
annual depreciation rate that is somewhat higher than the range of values reported
in Kostenbauer (2001). However, this value is much lower than the depreciation
rate for capital which is set to ±k = 0.023, implying an annual depreciation of the
capital stock of 9.5%.
We treat non-residential construction as part of business fixed investment but
exclude residential construction. Consistent with this classification, the capital
17 Consistent with the model, to calculate these ratios, we measure gross domestic product as the
sum of the consumption, residential investment, business fixed investment (i.e., excluding
inventory accumulation) and net exports. Since the real national accounts aggregates are
produced on a chain Fisher basis, we calculate these ratios using the nominal series.
18 The discount factor of impatient households is in accordance with estimates of discount factors
for poor or young households (e.g., Lawrance 1991) and falls into the empirical distribution for
discount factors estimated by Carroll and Samwick (1997).
19 The value of the loan-to-value ratio m should reflect the typical loan-to-value ratio for a
constrained household. This household, which we think of as being a first-time home buyer,
borrows the maximum possible against his real estate holdings. Ultimately, we would like to
incorporate information from observed financial variables such as mortgage debt into the
model. However, aggregate measures of mortgage debt in Canada include debt held by
unconstrained households that have had time to accumulate other assets and are better thought
of as patient consumers. In future work, we may be able to exploit information from microdata
to determine a more appropriate target debt-to-asset ratio.
share in the production of final goods, ° = 0.23, is lower than is typically used in
models that aggregate all types of capital. The depreciation rate for capital along
with the capital share imply a ratio of business fixed investment to GDP of about
0.165, approximately that seen in the data.
We set the elasticity of demand for individual domestic intermediate goods
so as to give an average markup of 5% in steady state. Individual imported inter-
mediate goods have the same elasticity of demand. Following previous studies,
we set the share of imported goods in the final domestic goods basket, !, to 0.3.
3.3. Prior distributions

Consistently with previous studies, we use inverse gamma priors on all the struc-
tural parameters governing the standard deviations of the shocks. For the per-
sistence parameters of the shock processes, we choose a beta distribution with a
prior mean of 0.5 and standard deviation of 0.25.
As in Iacoviello and Neri (2010), we set the prior mean on the income share of
unconstrained households to 0.65, the standard deviation is set equal to 0.075.
Campbell and Mankiw (1990) estimate the fraction of constrained agents from
US macro data to be near 50%. Estimates based on micro data for the US (Jappelli
1990) and the UK (Benito and Mumtaz 2006) put the share of the population
that is liquidity constrained between 20% and 40%.
We set a prior mean for the probability that a retailer will be unable to adjust
prices, μ, to 0.5 implying that retail prices are fixed for two quarters on average.
This is in line with the evidence on the price-setting behaviour of Canadian firms
reported in Amirault et al. (2006). The median firm in their survey sample ad-
justed prices two to four times a year. We use the same prior distributions for the
frequency of price adjustment by importers and export retailers in the foreign
economy. We also centre the prior mean for the frequency of wage adjustment
at 0.5. Similar priors for wage and price stickiness appear in Smets and Wouters
(2007) and Adolfson et al. (2007).
The prior means for the monetary policy rule are similar to those used in Smets
and Wouters (2007) and the standard deviations are relatively large allowing the
priors to be consistent with the estimates for Canada by Lam and Tkacz (2004)
and also the Canadian policy rules discussed in Côté et al. (2004). We use a beta
distributed prior on the inverse of the coefficient on inflation (½¼−1 ). Ultimately,
this results in a prior that is less informative than the normal distribution that is
more widely used. The prior mean on the smoothing parameter ½r is set to 0.5
and the prior mean for ½y is 0.125.
For the remaining of the parameters, we set priors that are in line with the rest
of the literature. We set the prior mean of the habit parameter in consumption b
to 0.7 with a standard deviation of 0.05. The prior mean for the labour supply
elasticity is set to 2.0. The prior mean for the elasticity of the country risk premium
with respect to the ratio of foreign debt-to-output, Á is set equal to 0.001. For the
fixed capital and housing capital adjustment costs we chose a gamma distribution
with mean of about 1 and a standard deviation of 0.5 in both cases. Tables 1
to 3 summarize the prior distributions of the estimated parameters. At our prior

means, the model is able to match a set of key steady-state ratios observed in our
data sample.
4. Empirical results
In the following, we report the estimates for the two nested models: the model
with collateral constraints and the frictionless version of the same model. We
refer to our benchmark model as the FA model since it has an active financial
accelerator and the model without the borrowing constraints as with the NoFA
model. In this latter framework, the economy is populated only by patient agents,
i.e., ¯2 = ¯1 , that derive utility from housing services, purchase capital and rent it
to the intermediate goods producer. All other features of the model are preserved.
We report the posterior mean and 95% probability interval for the structural
parameters, along with their priors, for the FA model in table 1. Except where
noted, most of the parameters are within the ranges specified in the priors.
The habit-persistence parameter b is estimated to be 0.79, while the long-run
elasticity of labour demand ´ is 0.55; the estimated habits are on the high end of
our prior, and the labour elasticity is on the lower end. The estimate of the wage
share of unconstrained households, ®, is about 0.62. Iacoviello and Neri (2010)
estimates for the US economy report a wage share of unconstrained households
of about 0.68 and 0.81, respectively, over the 1965–1982 and 1982–2006 periods.
The mean estimate of Calvo price stickiness for domestic goods μ d implies
an average duration of price stickiness of about six quarters. Such estimates for
average price stickiness are high relative to findings on price adjustment from
micro studies, but they are in line with previous DSGE models’ estimates–even
with more elaborate systems of nominal stickiness (e.g., Smets and Wouters 2007;
Adolfson et al. 2007). Wage stickiness on the other hand is much lower than in
many other studies, with a typical wage being unchanged for only four months on
average. The price stickiness for imports μ m is about the same as for domestically
produced goods. However, price stickiness for exports μ x is much lower, with the
average export price being sticky for about only 1.25 quarters on average. The
long run elasticity of import demand ¾ is much lower (about 0.3) than that of
export demand ¾ f (about 1.5). Such estimates reflect a much faster response of
exports than imports to a change in the real exchange rate. This may reflect the
composition of exports and imports.
The estimated range of ½¼−1 implies a range for the inflation weight in the
monetary policy rule, ½¼ , from 1.4 to 2.1, while the weight on output, ½y , is fairly
small (between 0.01 and 0.06). The interest rate smoothing term, ½R , is between
0.41 and 0.68. The estimated policy rule coefficients are similar to those reported
in other studies (Ortega and Rebei 2006, Dib 2008, Dib, Gammoudi et al. 2008).
Table 1 also reports the results for the NoFA model. The estimates of the two
versions of the model do not highlight significant differences across parameters’
TABLE 1
Estimation results
Parameters Prior distribution Posterior – FA Posterior – NOFA

Mean St. dev. Mean 5% 95% Mean 5% 95%
Savers income ® B 0.650 0.075 0.623 0.561 0.683 – – –
share
Habit formation ° B 0.5 0.25 0.783 0.727 0.841 0.647 0.544 0.743
Slope of labour ´ G 2.000 1.000 0.548 0.282 0.793 0.617 0.210 0.929
supply
Adj. cost for Ãh G 1.000 0.500 1.172 0.866 1.442 1.140 0.849 1.428
housing
Adj. cost for Ãk G 1.000 0.500 1.610 0.961 2.271 1.829 1.135 2.524
capital
Price stickiness: μd B 0.500 0.100 0.839 0.797 0.881 0.848 0.808 0.884
Domestic
Price stickiness: μm B 0.500 0.100 0.808 0.758 0.863 0.818 0.763 0.870
Imports
Price stickiness: μx B 0.500 0.100 0.207 0.112 0.293 0.239 0.115 0.350
Exports
Price stickiness: μw B 0.500 0.250 0.333 0.282 0.389 0.305 0.250 0.355
Wages
Elast. of risk 8 IG 0.0010 Inf. 0.0006 0.0003 0.0010 0.0005 0.0002 0.0007
premium
UIP lag 8s B 0.250 0.15 0.102 0.019 0.175 0.097 0.015 0.169
Import demand ¾ G 1.000 0.500 0.345 0.190 0.504 0.367 0.194 0.534
Export demand ¾f G 1.000 0.500 1.642 1.119 2.131 1.397 0.887 1.853
Int. rate ½r B 0.500 0.25 0.528 0.400 0.660 0.459 0.332 0.594
smoothing
Response to ½¼−1 B 0.500 0.250 0.594 0.479 0.713 0.614 0.504 0.727
inflation
Response to ½y G 0.125 0.0625 0.033 0.010 0.055 0.028 0.007 0.046
output
Housing demand ½Ah B 0.500 0.25 0.976 0.959 0.994 0.962 0.939 0.989
Housing supply ½Ah B 0.500 0.25 0.935 0.899 0.971 0.939 0.900 0.979
Capital supply ½Ak B 0.500 0.25 0.502 0.340 0.669 0.449 0.267 0.637
Price markup ½p B 0.500 0.25 0.757 0.629 0.887 0.766 0.638 0.886
Labour supply ½L B 0.500 0.25 0.242 0.094 0.379 0.321 0.175 0.466
Technology ½z B 0.500 0.25 0.985 0.972 0.997 0.978 0.962 0.993
Import demand ½m B 0.500 0.25 0.904 0.865 0.943 0.926 0.892 0.960
Export demand ½x B 0.500 0.25 0.985 0.969 0.997 0.976 0.962 0.994
Exchange rate ½s B 0.500 0.25 0.942 0.912 0.978 0.970 0.949 0.990
Discount factor ½b B 0.500 0.25 0.225 0.030 0.404 0.659 0.547 0.777
Inflation objective ½IO B 0.500 0.25 0.994 0.989 0.999 0.991 0.984 0.999
Housing demand ¾j IG 0.300 Inf. 0.299 0.252 0.340 0.327 0.280 0.370
Housing supply ¾Ah IG 0.030 Inf. 0.033 0.029 0.037 0.033 0.030 0.037
Capital supply ¾Ak IG 0.020 Inf. 0.018 0.015 0.021 0.017 0.014 0.021
Price markup ¾P IG 0.020 Inf. 0.023 0.013 0.032 0.021 0.012 0.030
Labour supply ¾L IG 0.070 Inf. 0.082 0.052 0.110 0.069 0.045 0.093
Technology ¾z IG 0.010 Inf. 0.012 0.010 0.013 0.012 0.011 0.013
Monetary policy ¾MP IG 0.003 Inf 0.001 0.001 0.001 0.001 0.001 0.001
Import demand ¾m IG 0.020 Inf 0.022 0.019 0.024 0.022 0.020 0.024
Export demand ¾x IG 0.020 Inf. 0.036 0.026 0.045 0.032 0.024 0.039
Exchange rate ¾s IG 0.025 Inf. 0.019 0.012 0.027 0.028 0.016 0.040
Discount factor ¾b IG 0.030 Inf. 0.029 0.022 0.036 0.022 0.016 0.029
Inflation objective ¾IO IG 0.001 Inf. 0.002 0.001 0.002 0.002 0.002 0.003
NOTE: B = Beta, IG = Inverse Gamma.

estimates. The biggest differences in the parameter estimates between FA and

NoFA are related to preferences. The NoFA estimates of habits are lower than
the FA estimates, and the NoFA estimate of labour supply elasticity is higher
than the FA estimate. In addition, the estimated volatility and persistence of the
discount factor shock are higher in the NoFA model.
5. Model comparison: FA versus NoFA
Our objective is to document the role that collateral constraints play to enable
the model to fit the data over the business cycle. Initially, we compare the two
estimated versions of the model in terms of the overall goodness of fit over the
entire sample. Then, we investigate how collateral constraints affect the trans-
mission mechanism of a variety of shocks. Last, we illustrate the implications
for a key set of moments of interest in the data. To this purpose we compare the
two models with the performance of a Bayesian Vector Autoregression (BVAR)
estimated using the same data set.
Results presented below show that the data strongly favour the model with col-
lateral constraints. Collateral constraints mainly affect the transmission of shocks
that are directly linked to house prices. In particular, they enable the model to gen-
erate a positive response of aggregate consumption to housing demand shocks.
As a result, the model with collateral constraints performs better in matching
some key facts about consumption, particularly its correlation with GDP and
house prices.
5.1. Overall goodness of fit

In order to quantify how differences across the two estimated version of the
model affect the overall goodness of fit of the model, we first compute the Bayes
factor, i.e., an estimate of the ratio of the marginal likelihoods of the two models.
The model with collateral constraints displays a significantly higher log data
density compared to the frictionless version of the model. The difference of the
log Bayes factors is 3540.07 −3520.57 = 19.50. Thus, the Bayes factor (Jeffreys
1961; Kass and Raftery 1995) indicates decisive evidence in favour of the FA
model and implies a posterior odds ratio of e19.50 = 2.94 × 107 : 1 in favour of
FA. This means that in order for the model without collateral constraints to be
preferred we would need to attach a prior probability over this model 2.94 × 107
larger than the prior belief about the model with collateral constraints.
Since the Bayes factor tends to be sensitive to the priors, including those on
nuisance” parameters, we also calculate the ratio of the Schwarz criteria (Schwarz
1978) of the two competing models. This commonly used as a “prior-free” ap-
proximation of the Bayes factor, as it is essentially a ratio of the maximum like-
lihoods of the two models.20 In addition, the Schwarz criterion includes a penalty
20 One drawback of the Schwarz criterion is that the difference between it and the true Bayes factor
does not go to zero as T gets large. See Kass and Raftery (1995) for a discussion.
for the number of estimated parameters, which should reduce the advantage of
the FA model. We also calculate the log ratio of the Laplace approximations of
the marginal likelihood of both models, assuming flat priors on all parameters,
including standard deviation terms.
The log Bayes factor as measured by the Schwarz criterion is 22.4; the implied
posterior odds ratio of FA and NoFA is approximately 5.5 × 109 to 1 in favour of
FA. The log of the Laplace odds ratio is about 20.9, implying a posterior odds ra-
tio of 1.2 × 109 to 1 in favour of FA. The Laplace approximation and the Schwarz
approximation of the Bayes factor are within the same order of magnitude, and
both suggest that the data strongly favour the FA model over the NoFA model.21
Interestingly, the maximum likelihood estimate of alpha is about 0.63, similar to
the posterior mean estimated with the use an informative prior.
5.2. Transmission mechanism

In the following, we illustrate the role of collateral constraints in the transmission
of shocks. We compare the responses from the FA and NoFA model. Figure 2
displays the impulse responses for aggregate consumption from the FA model
evaluated at the mean estimates of the posterior distribution of the model (solid
line). The dashed lines represent the 95% probability interval of the IRFs of the
NoFA model.22 A 1% rise in a variable is denoted as 0.01 on the y-axis and the
number of quarters elapsed since the shocks are indicated on the x-axis.
Consumption displays important differences in response to housing prefer-
ence, housing investment and monetary policy shocks. The FA model generates a
stronger peak response of consumption to a monetary policy shock, as well as a
more persistent one. It also amplifies the decline in consumption after a housing
investment shock. Most striking is the case of a housing demand shock, which, in
the FA model, generates a positive consumption response that can clearly not be
produced by the model without collateral effects. The 95% probability interval of
the impulse responses of the NoFA model reports a negative response of aggre-
gate consumption to a positive housing demand shocks. As for the other shocks,
the FA model’s IRFs fall within the probability interval generated by the NoFA
model. Thus, the transmission of neutral technology, country risk premium and
export demand shocks, does not feature significant differences across models.
The housing preference shocks directly affect the demand for houses and are,
thus, commonly interpreted in the literature as housing demand shocks. In the
NoFA model, which resembles a standard representative agent model, consump-
tion falls in response to an housing preference shock because households give up
consumption to increase their housing expenses. In contrast, the model with col-
lateralized debt, the increase in house prices induced by a rise in housing demand,
21 We did find that the estimates of some of our structural parameters were sensitive to the
relaxation of the priors. In particular, the standard deviation of the monetary shock and the
parameter governing the degree of export price rigidity went to zero. For the maximum
likelihood estimation we set those parameters equal to zero a priori.
22 This means that 95% of the draws from the posterior distribution of parameters of the IRFs of
the NoFA model delivers IRFs that fall into the upper and lower dashed lines.
FIGURE 2 Mean responses of consumption to various shocks under the FA model (solid), vs. the 95% confidence bands under the NoFA model (dashed)
relaxes the borrowing constraint and improves the debt capacity of borrowers.
Thus, expansion of households’ credit allows them to also increase consumption
expenditures.
To illustrate the importance of different features of the model for the trans-
mission of housing preference shocks, figure 3 plots impulse responses from the
estimated FA model along with the responses obtained when: (i) the borrow-
ers make up a negligible fraction of the wage bill, i.e., ® = 1 (dashed line), (ii)
wages are flexible, i.e., μw = 0 (dotted line) and (iii) access to the international
bond market is more costly and Á rises from 0.0006 to 0.1 (dash-dotted line).
Regarding the presence of borrowing constrained households, we find that this
is a crucial assumption to obtain a positive response of consumption to housing
preference shocks (top left panel). Further, it also implies a more pronounced
rise in residential investment (top right panel).
The degree of access to the foreign bond market is another important factor
for the response of aggregate consumption to the shock. In fact, reduced access
to the foreign bond market (higher Á) increases the response of the the yield
spread and, thus, the real interest rate to this shock (not reported in the figure)
such that in equilibrium it is possible to satisfy the demand for loans through
a larger amount of domestic savings.23 Moreover, the reduced amount of loans
also dampens the increase in consumption expenditures and generates a larger
response in hours worked.
Finally, under flexible wages the increase in hours worked is reduced while the
interest rate rises by more. This occurs since, in the absence of wage stickiness,
the impact of the housing demand shock on the marginal cost and inflation is
exacerbated (not shown in the figure).
5.3. Business cycle properties

In this section, we compare the statistical properties of the model against those
of the data. We focus on the model characteristics at horizons that are most rele-
vant for policy makers, rather than just on unconditional moments. To generate
these moments in the data we estimate a Bayesian Vector Autoregression (BVAR)
model using the same data set.24 BVARs are a useful benchmark in this context
because they have good forecasting properties and impose much weaker restric-
tions on the data than DSGE models.25 The statistics we consider are essentially
23 Recall that the yield spread rises (above its steady-state value) when the real interest rate rises
above its steady-state value.
24 The variances from the BVAR were calculated from a BVAR with four lags estimated with a
Normal-Wishart prior (Kadiyala and Karlsson 1997), with the prior variance hyperparameter
set at 0.012, a lag decay proportional to 1=k 2 , and 13 degrees of freedom (the minimum
permissible) on the Inverse Wishart prior on the error covariance matrix. Further, only draws
from the posterior that resulted in a stationary process (permitting a finite unconditional
variance) were used, further restricting the BVAR.
25 In an early example, Schorfheide (2000) evaluates the ability of two DSGE models to match the
correlation between inflation and output produced by a VAR.
FIGURE 3 Impulse responses to a housing demand shock
the properties of the forecast errors of each model at different horizons up to two
years.
Standard deviations. In table 2, we report the standard deviations of selected
variables.26 These are conditional statistics that show the standard deviation of
the forecast of variable X at a four-quarter horizon relative to the standard de-
viation of GDP. We focus on the four-quarter horizon as an illustration, but the
results are broadly similar for horizons up to eight quarters.
Overall, the standard deviations are quite similar for the model with collateral
constraints (FA) and the model estimated with those effects constrained to zero
(NoFA). Both models are able to generate a high degree of volatility in residential
investment and house prices, though still less than in the VAR. In addition, both
models under predict the relative volatility of imports. In contrast, in both models
the volatility of consumption is higher than what generated by the VAR, though
consumption is somewhat less volatile in the model with the collateral effects.
The relative volatilities of inflation, the real exchange rate and the yield spread
are all close to their values in the data.
Cross-correlations. Table 3 reports the cross-correlations for the same selected
variables. We compute the correlation in the forecast errors of X and Y at a
26 From an aggregate perspective there are a number of reasons to think that house prices could
influence consumption decisions in Canada. First, residential structures and land account for a
large share of Canadian household sector wealth. A total of 68% of Canadian households own a
home and for many it represents their largest asset. Second, house price growth is associated
with higher household borrowing. The positive correlation between consumption and house
prices may be related to housing’s role as collateral. Between 2000 and 2007, the real price of
existing homes increased by 52%. At the same time, the ratio of household debt to GDP rose
dramatically from 58% in 2000 to 76% in 2007. By 2007 roughly 80% of Canadian household
debt was secured by real estate.
TABLE 2
Four-step ahead standard deviations, as ratio of stan-
dard deviation of GDP
VAR model FA model NoFA model
C 0.823 0.766 0.935
L 0.809 0.865 0.869
w 0.894 0.799 0.780
Ik 3.227 3.481 3.453
Ih 4.617 3.229 3.285
qh 2.894 2.322 2.346
¼ 0.213 0.248 0.252
Yx 2.475 2.379 2.355
Ym 2.624 2.023 1.874
s 2.830 2.509 2.425
Yield spr. 0.135 0.159 0.154
TABLE 3
Four-step-ahead correlations
VAR model FA model NoFA model
Correlation with GDP
C 0.672 0.643 0.598
L 0.452 0.319 0.365
Ik 0.408 0.544 0.508
Ih 0.715 0.284 0.207
¼ −0.113 −0.136 −0.140
Correlation with house prices
C 0.475 0.462 0.116
Ik 0.231 0.110 0.216
Ih 0.567 0.476 0.488
four-quarter horizon, rather than the infinite horizon correlation. The results are
qualitatively similar at the one-step and eight-step forecast horizons.
In the model, consumption and both types of investment are positively corre-
lated with GDP, as they are in the VAR. The model-implied correlations between
GDP and consumption are quite close to the correlation in the data and the cor-
relation of fixed capital investment implied by the models is slightly stronger.
Though the model with collateral effects generates a higher correlation between
residential investment and GDP it is still well below the correlation in the data.
Turning to cross correlations with real house prices, we see that the model with
collateral effects generates a correlation between consumption and real house
prices that is very close to the VAR. The collateral effects appear to be impor-
tant for this finding, since the model without those effects generates only a very
weak correlation. Both models produce a correlation between house prices and
residential investment that is close to that seen in the VAR.
Overall, the model with collateral effects matches some key facts about con-
sumption, particularly its correlation with GDP and house prices. In addition, it
produces a plausible correlation between housing investment and house prices,
despite a highly stylized housing production sector. Though the model is cap-
turing the procyclical nature of residential investment, the correlation is weak
relative to the data.
6. FA model
In the following, we investigate the importance of different shocks for business

cycle fluctuations. Further, we also consider whether the collateral effect helps to
account for fluctuations of aggregate consumption over history and in particular
over macroeconomic booms and busts cycles.
6.1. Variance decomposition

Table 4 shows the decomposition of the forecast error variance of output, infla-
tion, consumption, housing investment, house prices at the 1, 4, 8 and infinite
horizons in the FA model. House prices and residential investment are dominated
by the housing market shocks. Residential investment fluctuations are largely due
to the housing investment-specific shock, Ah , that accounts for about 60% of the
variance up to eight quarters ahead. Housing demand shocks, j , also account
for an important share, especially at longer horizons. This shock explains above
30% of the variance up to eight quarters ahead. At all horizons the variance of
house prices is due primarily to the housing demand shock, though the housing
investment-specific shock is not negligible.
Shocks to the target of the central bank, IO , are the main drivers of fluctu-
ations in inflation. Markup shocks, p , productivity shocks, z , and shocks to
the country risk premium (exchange rate), s , also play an important role in the
variance of inflation at all horizons.
Finally, we consider what drives GDP and aggregate consumption in our
model. The housing demand shock explain around 5% of the variance of con-
sumption at horizons up to four quarters, suggesting spillovers from the housing
market. Not surprisingly, the discount factor shock, b , accounts for large frac-
tion of the variance of consumption at very short horizons. In fact, this shock
directly affects the Euler equations of the agents. Aggregate productivity shocks,
z , and export demand shocks, m , also play a role in accounting for consumption
fluctuations at longer horizons. The importance of the export demand shock is
in part due to a long-lived rise in net foreign assets (wealth) that results from an
increased demand for domestic goods.
Housing market shocks also account for a around 4% of the variance of GDP,
making them about as important as shocks to the country risk premium and the
wage markup. The housing demand shocks alone account for about 2.5% of the
TABLE 4
Variance decomposition – FA
Hous. Hous. Disc. Techn. Inv. Exch. Exp. Other
sup. pref. fact. spec. rate dem.
House inv. Ah j b z Ak s x shocks
1 64.00 30.47 0.06 1.81 0.14 1.64 0.55 1.33
4 62.25 32.25 0.11 2.02 0.13 1.67 0.57 1.01
8 59.39 35.45 0.09 2.06 0.09 1.47 0.61 0.85
Uncond. 31.17 46.55 0.05 4.96 0.05 0.98 14.86 1.38
Inv. spec. Exch. rate Exp. dem. Other
House prices Ak s x shocks
1 2.49 82.54 0.17 4.90 0.39 4.43 1.50 3.57
4 2.73 83.07 0.29 5.19 0.35 4.31 1.47 2.60
8 3.03 84.59 0.22 4.93 0.21 3.52 1.45 2.06
Uncond. 8.72 68.23 0.08 6.26 0.13 2.12 12.53 1.93
Infl. obj. Exch. rate Markup Other
Inflation IO s p shocks
1 0.02 1.26 0.75 9.62 44.58 7.48 29.80 6.49
4 0.01 1.24 0.61 8.94 61.64 6.38 15.63 5.55
8 0.02 0.88 0.41 7.60 72.28 4.80 9.75 4.27
Unconditional 0.01 0.12 0.06 3.95 92.28 0.99 1.26 1.32
Infl. obj. Exch. rate Exp. dem. Other
Consumption IO s x shocks
1 0.93 5.11 70.00 6.43 1.25 4.87 5.79 3.50
4 1.83 5.93 32.25 17.49 1.41 11.78 16.51 8.26
8 1.86 3.17 15.50 25.54 0.90 13.89 25.33 7.87
Uncond. 0.38 1.22 1.25 21.33 0.08 3.71 66.71 0.89
Invest. spec. Imp. dem. Exp. dem. Other
GDP Ak M x shocks
1 1.63 4.02 9.72 16.93 8.56 6.73 12.43 11.17
4 0.66 3.63 4.95 39.00 10.32 3.10 6.27 11.68
8 0.36 2.43 2.53 55.14 7.25 1.79 5.50 9.04
Uncond. 0.08 0.71 0.53 81.74 1.63 1.02 7.57 2.64
GDP variation at eight quarters.27 Overall, demand shocks in general play a more
important role at short horizons, particularly import demand, m , and discount
factor shocks, b . At long horizons the neutral productivity shock accounts for
the bulk of the fluctuations in GDP.
Meanwhile, housing demand shocks explain less than 1% of GDP and con-
sumption in the NoFA model (table 5). The drivers of house prices and residential
investment in NoFA are almost identical to the results reported for FA: hous-
ing demand accounts for above 80% of short horizon variance of house prices
and housing demand and investment-efficiency shocks account for over 90% of
the variance of residential investment. Much of the variance of consumption at-
tributed to the housing demand shock under FA is attributed to the discount
factor shock in the model where collateral effects are constrained to be zero. The
discount factor shocks explain 50% of consumption variance at the four-quarter
horizon under NoFA but only 30% under FA. The greater importance of the
housing demand shock in the FA model and lesser importance of the consump-
27 Studies of the US have also found relatively small impacts of housing demand shocks on
aggregate output (see Jarocinski and Smets 2008 and Iacoviello and Neri 2010).
TABLE 5
Variance decomposition – NOFA
Hous. Hous. Disc. Techn. Inv. Exch. Exp. Other
sup. pref fact spec. rate dem.
Hous. inv. Ah j b z Ak s x shocks
1 62.26 31.91 0.32 1.69 0.05 2.32 0.28 1.18
4 60.75 33.34 0.42 1.86 0.04 2.46 0.31 0.81
8 59.15 35.14 0.36 1.94 0.03 2.42 0.39 0.57
Uncond. 42.07 36.47 0.22 3.98 0.05 3.47 13.06 0.7
Inv. spec. Exch. rate Exp. dem. Other
House prices Ak s x shocks
1 2.43 82.49 0.82 4.36 0.14 6.01 0.73 3.03
4 2.77 82.58 1.04 4.61 0.11 6.10 0.77 2.03
8 3.22 83.21 0.85 4.59 0.07 5.74 0.92 1.40
Uncond. 12.11 61.45 0.41 6.21 0.11 6.77 11.90 1.05
Infl. obj. Exch. rate Markup Other
Inflation IO s p shocks
1 0.06 0.02 3.96 8.70 49.13 6.38 27.90 3.82
4 0.06 0.02 3.73 7.77 64.74 5.14 15.61 2.93
8 0.05 0.01 2.67 6.59 75.05 3.86 9.66 2.09
Uncond. 0.02 0.01 0.47 3.78 91.42 1.73 1.63 0.94
Infl. obj. Exch. rate Export dem. Other
Consumptions IO s x shocks
1 0.41 0.31 72.09 8.98 0.52 10.39 2.74 4.55
4 0.76 0.58 50.81 17.19 0.23 19.03 5.38 6.01
8 1.08 0.87 32.68 24.94 0.13 25.71 9.10 5.49
Uncond. 0.50 0.55 4.31 17.84 0.02 15.99 57.88 2.90
Inv. spec Imp. dem. Exp. dem. Other
GDP Ak m x shocks
1 1.83 0.91 10.88 16.43 7.02 38.70 16.68 7.55
4 0.91 0.47 9.92 40.07 8.32 20.98 9.69 9.63
8 0.56 0.31 5.59 57.47 6.19 13.28 8.21 8.39
Uncond. 0.17 0.12 1.57 79.98 1.85 3.78 8.22 4.32
tion preference shock, suggests that the borrowing constraints are helping the
model to capture some of the co-movement between consumption and house
prices.
6.2. Historical decomposition

In the following, we are interested in how well the model can explain particular
episodes in the Canadian business cycle where financial frictions are likely to have
been important.
We quantify the impact of collateral effects implied by our model in thet
following way. We compare consumption over history against a counterfactual
consumption path produced by turning off the collateral mechanism in the model
(setting ® = 1) using the same historical shocks to generate a new Kalman
smoothed estimate for consumption. The difference in the consumption path
generated by this latter specification and the actual consumption path represents
the contribution of collateral effects. In figure 4, we plot the contribution of the
collateral effect to the year-over-year growth rate of consumption together with
the level impact (dotted line). The figure reveals a number of interesting insights.
First, much of the growth in consumption in the early part of the housing boom
of the late 1980s is attributed to collateral effects. This positive effect peaked in late
1986 but continued to have a positive effect on consumption growth until 1989.
Further, after 1989 the collateral effects begin to negatively affect consumption
growth and have a pronounced negative impact on consumption in 1991. The
sharp collateral effect on consumption also occurs in 1982, suggesting that it an
important role in accounting for consumption dynamics in recessions.
Finally, we consider the post-2000 period, during which many OECD coun-
tries, including Canada, have seen sharp increases in house prices and consump-
tion. Our model suggests that collateral effects contributed as much as 1% to
yearly consumption growth in 2000 and had a positive effect for most of the
remainder of the sample. This contribution is less than in the period from 1986
to 1990. One reason might be that the house price increases since 2000 have been
more gradual than in the late 1980s when they achieved a comparable peak in
half the time, three years instead of six. See figure 1.
Explaining the differences between the 1980s housing boom and the recent
one is thus partly due the fact that the housing demand shocks were more
important in the earlier period. The main differences among the two booms
are related to the behaviour of residential investment and external factors. In
fact, unlike the real house price, residential investment does not continue to rise
after 2005 (though well above trend). To explain the fact that prices continue to
rise but housing construction does not, the model uses a decline in the housing-
investment efficiency shock. Thus, residential investment becomes more costly
and the housing stock more difficult to adjust. In the housing sector, this might
be the result of bottlenecks in production, including the difficulty in finding and
0.04
0.03 Year-to-year growth Level
0.02
0.01
–0.01
–0.02
–0.03
–0.04
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
FIGURE 4 Contribution of collateral effects to consumption

keeping skilled trades and reduced availability of land with access to public util-
ities and desired amenities. Of course this is speculative and worthy of attention
in future research.
External developments are also a major difference between the late 1980s and
the period after 2000. A decomposition of consumption over this period shows
a rising contribution from the country-risk premium. This shock turns out to
be very important for capturing the pronounced rise in the real exchange rate
vis-à-vis the United States. A key factor driving the exchange rate movement in
the data is a large improvement in Canada’s terms of trade. The result in the
model is a sharply increasing net foreign asset position. The long-lived effects
on wealth lead households to consume more and work less. One key distinction
between a positive housing demand and a negative risk premium shock is that
the latter implies a reduction in hours worked. Together these two shocks are able
to generate rising consumption and house prices and relatively little movement
in hours worked consistent with the data from 2005 onward.
Summarizing, housing collateral-induced spillovers accounted for a large share
of consumption growth during the housing boom of the late 1980s and the sharp
declines in consumption growth in the early 1990s. They also somewhat con-
tributed to boost consumption in the early part of the 2000s housing boom.
7. Conclusion
We estimate an open-economy DSGE model with residential investment and

collateral constraints using time-series for Canada. In this model, housing plays
a key role as collateral and house prices add a new transmission channel of
aggregate shocks to consumption. Our goal is to assess the empirical support for
housing collateral effects on the macroeconomy and, especially, on consumption.
We compare two estimated versions of the model, one with the financial accel-
erator effects (FA) and one where these effects are removed (NoFA). We find that
the FA model has a better fit to the data as measured by Bayes Factor compar-
isons. The FA model’s main empirical advantage is in explaining the dynamics
of consumption and its correlation with house prices. Overall, the main impact
of collateral constraints on the dynamics of our model come from the model
response to a housing demand shock.
A positive housing demand shock increases the price of housing and the value
of collateral, improving the borrowing capacity of credit constrained agents. As
a result, our estimated model generates an increase in aggregate consumption
after a rise in housing prices. The model attributes an important role to housing
demand shocks for the consumption boom in the late 1980s and the drop in
consumption that occurred in the recessions of the 1980s and 1990s. We find that
this shock has also been important in the recent housing boom, but, relative to the
1980s, external factors have played a larger role in accounting for business cycle
fluctuations in the housing market and non-housing components of consumption.
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Consumption, Housing Collateral and The Canadian Business Cycle

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Consumption, Housing Collateral and The Canadian Business Cycle

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Consumption, housing collateral and the

Canadian business cycle

Résumé. Consommation, bien immobilier comme garantie et le cycle d’affaires canadien.

JEL classiﬁcation: E32, E44, G12, O40

Canadian Journal of Economics / Revue canadienne d’économique, Vol. 49, No. 1

0008–4085 / 16 / 207–236 / © Canadian Economics Association

of housing demand shocks. In the model without collateral constraints, a posi-

The economy is populated by two types of households of unit mass: patient

Borrowers. Impatient households maximize their stream of expected future utility

2.2. Intermediate good production

2.3. Final good

2.3.1. Wholesale goods

where m,t is a shock to the demand of imported goods.

2.4. Capital producers

Capital production is also subject to an adjustment cost

where qtk is the capital price and ³t =¯1 Uc1, t+1

2.5. Housing producers

Housing production is also subject to an

2.6. Monetary policy

2.7. Market clearing conditions

2.8. Rest of the World

2.8.1. Shock processes

3. Data and model estimation

The vector of structural parameters of the model, 3, describing preferences,

3.1. The data

Consumption Residential investment Capital investment

0.1 0.2 0.2

–0.05 –0.4 –0.4

Real wage Inflation Yield spread

Real exchange rate

FIGURE 1 Detrended data series used in estimation

as a quarterly rate. We subtract 0.5% (the Bank of Canada’s inﬂation target

3.2. Calibrated parameters

3.3. Prior distributions

to 3 summarize the prior distributions of the estimated parameters. At our prior

Parameters Prior distribution Posterior – FA Posterior – NOFA

NOTE: B = Beta, IG = Inverse Gamma.

estimates. The biggest differences in the parameter estimates between FA and

5. Model comparison: FA versus NoFA

5.1. Overall goodness of ﬁt

5.2. Transmission mechanism

5.3. Business cycle properties

FIGURE 3 Impulse responses to a housing demand shock

In the following, we investigate the importance of different shocks for business

6.1. Variance decomposition

6.2. Historical decomposition

0.03 Year-to-year growth Level

FIGURE 4 Contribution of collateral effects to consumption

We estimate an open-economy DSGE model with residential investment and

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