Iacoviello 2005

House Prices, Borrowing Constraints, and Monetary Policy in the Business Cycle
Author(s): Matteo Iacoviello

Source: The American Economic Review , Jun., 2005, Vol. 95, No. 3 (Jun., 2005), pp. 739-
764
Published by: American Economic Association
Stable URL: https://www.jstor.org/stable/4132738
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House Prices, Borrowing Constraints, and Monetary Policy in
the Business Cycle
By MATTEO IACOVIELLO*
I develop and estimate a monetary business cycle model with nominal loans and
collateral constraints tied to housing values. Demand shocks move housing and
nominal prices in the same direction, and are amplified and propagated over time.
The financial accelerator is not uniform: nominal debt dampens supply shocks,
stabilizing the economy under interest rate control. Structural estimation supports
two key model features: collateral effects dramatically improve the response of
aggregate demand to housing price shocks; and nominal debt improves the sluggish
response of output to inflation surprises. Finally, policy evaluation considers the
role of house prices and debt indexation in affecting monetary policy trade-offs.
(JEL E31, E32, E44, E52, R21)
"The population is not distributed between A long tradition in economics, starting with
debtors and creditors randomly. Debtors Irving Fisher's (1933) debt-deflation explana-
have borrowed for good reasons, most of tion of the Great Depression, considers financial
which indicate a high marginal propensity factors as key elements of business cycles. In
to spend from wealth or from current in-
this view, deteriorating credit market condi-
come or from any other liquid resources
tions, like growing debt burdens and falling
they can command. Typically their indebt-
edness is rationed by lenders [...]. Business asset prices, are not just passive reflections of a
borrowers typically have a strong propen- declining economy, but are themselves a major
sity to hold physical capital [...]. Their de- factor depressing economic activity.
sired portfolios contain more capital than Although this "credit view" has a long his-
their net worth [...]. Household debtors are tory, most theoretical work on this subject had
frequently young families acquiring homes been partial equilibrium in nature until the late
and furnishings before they earn incomes to 1980s, when Ben Bernanke and Mark Gertler
pay for them outright; given the difficulty of (1989) formalized these ideas in a general equi-
borrowing against future wages, they are
librium framework. Following their work, var-
liquidity-constrained and have a high mar-
ious authors have presented dynamic models in
ginal propensity to consume."
-James Tobin, Asset Accumulation and which financing frictions on the firm side may
Economic Activity amplify or propagate output fluctuations in re-
sponse to aggregate disturbances: examples in-
clude the real models of Nobuhiro Kiyotaki and
* Department of Economics, Boston College, ChestnutJohn Moore (1997) and Charles Carlstrom and
Hill, MA 02467 (e-mail: iacoviel@bc.edu). I am deeply
indebted to my Ph.D. advisor at the London School of
Timothy Fuerst (1997), and the sticky-price
Economics, Nobuhiro Kiyotaki, for his continuous help model of Bernanke et al. (1999). Empirically,
and
invaluable advice. I thank Fabio Canova, Raffaella Giaco- various studies have shown that firms' invest-
mini, Christopher House, Peter Ireland, Raoul Minetti,ment decisions are sensitive to various measures
Claudia Oglialoro, Frangois Ortalo-Magnd, Marina Pavan, of the firms' net worth (see Glenn Hubbard,
Christopher Pissarides, Fabio Schiantarelli, two anonymous
referees, and seminar participants at the Bank of England,
1998, for a review). At the same time, evidence
Boston College, the European Central Bank, the Ente Luigi of financing constraints at the household level
Einaudi, the Federal Reserve Bank of New York, the Fed-has been widely documented by Stephen Zeldes
eral Reserve Bank of St. Louis, the London School of
(1989), Tullio Jappelli and Marco Pagano
Economics, the NBER Monetary Economics Meeting, and
Northeastern University for their helpful comments on var-
(1989), John Campbell and Gregory Mankiw
ious versions of this work. Viktors Stebunovs provided(1989), and Christopher Carroll and Wendy
superb research assistance. Dunn (1997).
739

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740 THE AMERICAN ECONOMIC REVIEW JUNE 2005
While these studiesitive

havedemand highlighted
shock. When demand rises, the con- i
portance of financialsumer and asset prices
factors forincrease: the rise in asset
macroecono
fluctuations, to dateprices
there
increases the
has borrowing
been capacity
no of the
syst
debtors,
atic evaluation of the extentallowing them
to to spend and invest
which a gen
more. Thefinancial
equilibrium model with rise in consumer prices reduces the
frictions
explain the aggregate time-series
real value of their outstanding debtevidenc
obligations,
the one hand, and be used
positively for
affecting monetary
their net worth. Given thatpo
borrowers
analysis on the other. have a higher
This is thepropensity to spend
perspec
adopted here. From the than lenders, the net effect on
modeling demand is posi-
point of v
my starting point is tive, and acts as a powerful
a variant of amplification
the Bernan mech-
al. (1999) new-Keynesian anism. However,setup inthe
while it amplifies which
demand
dogenous variations shocks, in the consumer price inflation sheet
balance dampens theof
firms generate a "financial shocks that induceaccelerator" by
a negative correlation between
hancing the amplitude output and of business
inflation: for instance, adversecycles
supply
this framework, I add shockstwo
are beneficial
mainto borrowers' net worth if
features: co
eral constraints tied to real estate values for obligations are held in nominal terms. Hence, un-
firms, as in Kiyotaki and Moore (1997); and, likeforthe previous papers, the financial accelerator
a subset of the households, nominal debt. The really depends on where the shocks come from:
reason for housing' collateral is practical the
andmodel features an accelerator of demand
substantial: practical because, empirically, a
shocks, and a "decelerator" of supply shocks.
The transmission mechanism described above
large proportion of borrowing is secured by real
estate; substantial because, although housing
is at the root of the model's success in explaining
two salient features of the data. First, collateral
markets seem to play a role in business fluctu-
ations,2 the channels by which they affecteffects
the on the firm and the household allow match-
economy are far from being understood.ing Thethe positive response of spending to a housing
reason for having nominal debt comes fromprice
the shock.3 Second, nominal debt allows the
widespread observation that, in low-inflation model to replicate the hump-shaped dynamics of
countries, almost all debt contracts are in nom- spending to an inflation shock. Such improve-
inal terms, even if they appear hard to justifymentson in the model's ability to reflect short-run
welfare-theoretic grounds: understanding their dynamic properties are especially important,
implications for macroeconomic outcomes is given
a that several studies (e.g., Jordi Gall, 2004;
crucial task. Peter Ireland, 2004b) have stressed the role of
In addition, I ask whether the model is able to nontechnology and nonmonetary disturbances
explain both key business cycle facts and the in understanding business fluctuations.
interaction between asset prices and economic Finally, I address and answer two important
activity. To this end, I estimate the key struc- policy questions. First, I find that allowing the
tural parameters by minimizing the distance be- monetary authority to respond to asset prices
tween the impulse responses implied by the yields negligible gains in terms of output and
model and those generated by an unrestricted inflation stabilization. Second, I find that nom-
vector autoregression. The estimates are both inal (vis-a-vis indexed) debt yields an improved
economically plausible and statistically signifi- output-inflation variance trade-off for the cen-
cant. They also provide support for the two tral bank: this happens because the sources of
main features of the model (collateral con- trade-offs in the model do not get amplified,
straints and nominal debt). In the concluding since such shocks, ceteris paribus, transfer re-
part of the paper, therefore, I use the estimated sources from lenders to borrowers during a
model for quantitative policy analysis. downturn.
The model transmission mechanism works as
follows. Consider, for sake of argument, a pos-
3 In the VAR below I document a significant two-way
interaction between housing prices and GDP. Aggregate de-
S With a slight abuse of notation, I use the terms "real mand effects from changes in housing wealth have also been
estate," "assets," and "houses" interchangeably in the paper.documented elsewhere; see, for instance, Case et al. (2001).
2 See, for instance, International Monetary Fund (2000); 4 See, for instance, Jeffrey Fuhrer (2000), as well as the
VAR evidence below.
Matthew Higgins and Carol Osler (1997); Karl Case (2000).

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VOL. 95 NO. 3 IACOVIELLO: HOUSE PRICES, BORROWING CONSTRAINTS, AND MONETARY POLICY 741
response of R response of t response of q response of Y

w 2 2
0.2 10.2 1 1
000 0
-0.2 -0.21
0 10 20 0 10 20 0 10 20 0 10 20
kt 2 2
2*A 0.2 0.2 1 1
" -0.2 -0.2

0 10 20 0 10 20 0 10 20 0 10 20
cr -- 2 2
200.20
0.20
1 .1
1.
Ad Z. -1 - 1
-0.2 -0.2
0 10 20 0 10 20 0 10 20 0 10 20
2 2
m -0.2 -0.2
2
=-1 -1 0.
0 10 20 0 10 20 0 10 20 0 10 20
quarters quarters quarters quarters
FIGURE 1. VAR EVIDENCE, UNITED STATES
Notes: VAR estimated from 1974Q1 to 2003Q2. The dashed lines indicate 90-
ordering of the impulse responses is R, 7r, q, Y. Coordinate: percent deviation from
from a VAR
The paper is organized as follows. with detrended
Section I real GDP (Y),
presents some VAR evidence on change in the prices
housing log of GDP deflator (7r), de-
and the business cycle. Section trended real house
II presents prices (q), and Fed Funds
the
basic model. Section HI extends the basic model rate (R) from 1974Q1 to 2003Q2.5 I use this
by including a constrained household sector and VAR to document the key relationships in
the data and, later in the paper, to choose the
by allowing for variable capital. Section IV esti-
mates the structural parameters of the model. Sec-
tion V analyzes its dynamics, while Section VI
looks at housing prices and debt indexation for the
5 The Fed Funds rate is the average value in the first
formulation of systematic monetary policy. Con-
month of each quarter. The house price series (deflated with
cluding remarks are contained in Section VII. the GDP deflator) is the Conventional Mortgage Home
Price Index from Freddie Mac. The VAR included a time
I. VAR Evidence on Housing Prices and the trend, a constant, a shift dummy from 1979Q4, and one lag
Business Cycle of the log of the CRB commodity spot price index. Two lags
of each variable were chosen according to the Hannah-
Quinn criterion. The logs of real GDP and real housing
Figure 1 presents impulse responses (with
prices were detrended with a band-pass filter that removed
90-percent bootstrapped confidence bands) frequencies above 32 quarters.

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parameters of the extended

estate is fixed in the model inwhich
aggregate, however, a way
guaranteesresponses.
match the VAR impulse a variable price of housing. This
Here and in the rest assumption
of the is not crucial to the
paper, thepropagation
variabl
mechanism: I will show below
are expressed in percentages and that collateral
in quart
rates. The shocks are orthogonalized
effects in the
can generate sizeable amplification, even
when theordering
der R, 7r, q, and Y. The share of real estate in production
did not is af
small.
the results substantially: as I will show belo
such an ordering alsoAs renders
their activities are the
somewhatVARconven- and
model more directly tional, I start with the patientThe
comparable. households'
res
suggest that a modelproblem.
of the interaction betw
house prices and the business cycle has to
liver: A. Patient Households
(a) A negative response of nominal

The household sector (denoted prices,
with a prime) r
housing prices, and GDP
is standard, to
with the tight
exception mone
of housing (ser-
(Figure 1, first row);
vices) in the utility function.6
(b) A significant negative response
Households maximize a lifetime utilityof
func- r
housing prices and a bynegative but sma
tion given
response of output to a positive inflatio
disturbance (second row); and oo
(c) A positive comovement of asset prices

output in responseEo t=O
E P3'(In
to c' asset
+ j In h,' - (L')/rl
price + X ln(M'/P,))
shock
(third row) and to output shocks (fourt
row). Taken together,
where Eotheis thetwo rows
expectation high-
operator, 3 E (0,
light a two-way interaction between
is the discount factor, hous
c' is consumption at t,
ing prices and output.
denotes the holdings of housing, L' are hours
work (households work for the entrepreneur
In the rest of the paper,
and Mt/P, are I money
developbalances and
divided est
by th
mate a model that is consistent with these facts
price level. Denote with qt Q/Pt the r
and that can be used for policy analysis. I start housing price, with w= -- W]/P, the real wa
with a basic model, which conveys the intuition.Assume that households lend in real terms -b'
(or borrow b' Bt/P,) and receive back
II. The Basic Model
-R, B'-_ 1/P,, where R,_ is the nominal in-
terest rate on loans between t - 1 and t, so that
Consider a discrete time, infinite horizon obligations are set in money terms. Denoting
economy, populated by entrepreneurs and pa- with A the first difference operator, the flow of
tient households, infinitely lived and of measure funds is
one. The term "patient" captures the assumption
that households have lower discount rates than
firms and distinguishes this group from the im- (1) ct + qAhf + R,_ b:- l1/r,t
patient households of the extended model (in = b' + w,'L, + F, + T' - AM/Pt
Section III). Entrepreneurs produce a homoge-
neous good, hiring household labor and com-where wr, - P/P,_ , denotes the gross inflation
bining it with collateralizable real estate. rate, F, are lump-sum profits received from the
Households consume, work, and demand real
estate and money. In addition, there are retailers
and a central bank. Retailers are the source of
6 Javier Diaz-Gimenez et al. (1992) use a similar device
nominal rigidity. The central bank adjusts
in an OLG model of the banking and household sector. I do
money supply and transfers to support an inter-
not include imputed rents in my model definition of output;
est rate rule. this does not affect the results of the paper in any significant
way. I also assume that housing and consumption are sep-
In order to have effects on economic activity arable: Bernanke (1984) studies the joint behavior of the
from shifts in asset holdings, I allow housing consumption of durable and nondurable goods and finds that
investment by both sectors. I assume that real separability across goods is a good approximation.

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retailers (described below), and the last two b, ? mEt(qt+ hrt+1/Rt).

terms are net transfers from the central bank that
are financed by printing money. Solving this To make matters interesting, one wants a
problem yields first-order conditions for con-
steady state in which the entrepreneurial return
sumption (2), labor supply (3), and housing
to savings is greater than the interest rate, which
demand (4): implies a binding borrowing constraint. At the
same time, one has to ensure that entrepreneurs
1 = R t will not postpone consumption and quickly ac-
c' w,,1c',! cumulate wealth so that they are completely
(2) c t +1Ct+1 self-financed and the borrowing constraint be-
(3)()wt
w =(L)-'/c'
t t comes nonbinding. To deal with this problem, I
assume that entrepreneurs discount the future
qt J qt+ 1 more heavily than households. They maximize
(4) Ct+PE,
h, c,+1)"
The first-order condition with respect to E0 > ;y'ln c,
M'/P, yields a standard money demand equa- t=O
tion. Since I focus in what follows on interest

rates rules, money supply will always meet
where y < 3,7 subject to the technolog
money demand at the desired equilibrium nom- straint, the borrowing constraint, and th
inal interest rate. As utility is separable lowing
in flow of funds:
money balances, the quantity of money has no
(6) Y,/X, + bt = ct + qtAht
implications for the rest of the model, and can
be ignored.
+ Rt_Ibt_l/r nt + wt'L
B. Entrepreneurs
where Rt_ bt_1/7T t in (6) reflects the a
Entrepreneurs use a Cobb-Douglas constant tion that debt contracts are set in nominal
so that price changes between t - 1 and
returns-to-scale technology that uses real estate
affect the realized real interest rate. I use this
and labor as inputs. They produce an interme-
diate good Y, according to assumption on empirical grounds: in low-inflation
countries, almost all debt contracts are set in
nominal terms.8
(5) Yt = A(ht,_ 1)(Lt)' - v
where A is the technology parameter, h is real7 Entrepreneurs are not risk neutral. Models of agency
costs and business cycles typically assume risk-neutral en-
estate input, and L is the labor input. Output
trepreneurs. Carlstrom and Fuerst (2001) discuss the issue.
cannot be transformed immediately into con- In modeling firms' behavior in a model of monetary shocks,
sumption c,: following Bernanke et al. (1999), I
agency costs, and business cycle, they consider two alter-
assume that retailers purchase the intermediate
natives. In one, entrepreneurs are infinitely lived, risk neu-
tral, and more impatient than households: net worth sharply
good from entrepreneurs at the wholesale price
responds to shocks, as the elasticity of entrepreneurial sav-
P" and transform it into a composite final good,
ings to changes in the real rate of interest is infinite. In the
whose price index is Pt. With this notation, Xt - a constant fraction of entrepreneurs dies each period, so
other,
P,/P,' denotes the markup of final over interme-
that net worth responds passively and slowly to changes in the
diate goods. real rate: in the aggregate, this is equivalent to a formulation in
which entrepreneurs are extremely risk averse. Log utility can
As in Kiyotaki and Moore (1997), I assume be a considered as shorthand between these two extremes.
limit on the obligations of the entrepreneurs. 8 With risk-averse agents, nobody seems to get any ben-
Suppose that, if borrowers repudiate their debt
efit in terms of expected utility from lack of indexation:
obligations, the lenders can repossess the bor-
presumably, if contracts were indexed, there would be wel-
fare gains. However, surprisingly few loan contracts are
rowers' assets by paying a proportional trans-
indexed in the United States, where even 30-year govern-
action cost (1 - m)E,(qt,+ 1h). In this case the
ment and corporate bonds are not indexed. In Sections II E
maximum amount Bt that a creditor can borrow
and VI A, I discuss how the results of the paper change
is bound by mEt(Qt+ ,ht/R). In real terms: when indexed debt is assumed.

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In this case,
Define At as the time t the model would become
shadow value asymmet-
of t
ric around
borrowing constraint. The its first-order
stationary state. In bad times,
condi
for an optimum are the would
entrepreneurs consumption
be constrained; in good E
equation, real estate times,
demand,they might beand labor
unconstrained. dem
In such a
case, a linear approximation around the deter-
1 yRt sults. In the paper, I take as given that

ministic steady state might give misleading re-
(7) - E , + ARt
Ct ("7Tt +Ic=t +1 uncertainty is "small enough" relative to degree
1 y/ __ N of impatience so as to rule out this possibility.
(8) qt= Eimv X.t
c, ct. t+ qt +1 In Appendix C, I present evidence from nonlin-
ear simulations that backs this assumption.9
Ct+ IAm Xt+ lht
C. Retailers
+ ktmTt + l qt + )
To motivate sticky prices I assume implicit

(9) wt = (1 - v) Y/(X,Lt). costs of adjusting nominal prices and, as in
Bernanke et al. (1999), monopolistic competi-
Both the Euler and the housing demand tion at the retail level. A continuum of retailers
equations differ from the usual formulations be- of mass 1, indexed by z, buy intermediate goods
Y, from entrepreneurs at P" in a competitive
cause on
plier of the
the borrowing
presence ofconstraint.
At, the Lagrange
A, equalsmulti-
the market, differentiate the goods at no cost into
increase in lifetime utility that would stem from Yt(z), and sell Yt(z) at the price Pt(z). Final
borrowing R, dollars, consuming (equation [7]) or
investing (equation [8]) the proceeds, and reduc- egoods are Yt
> 1. Given = aggregate
this (fo Y,(z)-output
1 dz)EE -1 where
index,10 the
ing consumption by an appropriate amount the price index is Pt = (fo Pt(z)' - dz)1n - ", so that
following period. each retailer faces an individual demand curve
Without uncertainty, the assumption y < P3 of Y,(z) = (P,(z)/P,)-Y{..
guarantees that entrepreneurs are constrained in Each retailer chooses a sale price Pt(z) taking
and around the steady state. In fact, the steady- P' and the demand curve as given. The sale
state consumption Euler equation for the house- price can be changed in every period only with
hold implies, with zero inflation, that R = 1/03,
probability 1 - 0. Denote with Pt(z) the "reset"
the household time preference rate. Combining price and with Yt+k(z) = (Pt(z)/Pt+k)-Yt+k
this result with the steady-state entrepreneurial the corresponding demand. The optimal P*(z)
Euler equation for consumption yields: A = solves:
(p - y)/c > 0. Therefore, the borrowing con-

straint will hold with equality: (11)
(10) bt = mEt(q,., hrt, + IIRt). 0 P*(Z) X

Matters are of course thornier when there is
O kEt At,k X
uncertainty. The concavity of the objective
function implies in fact that, in some states of
the world, entrepreneurs might "self-insure" by 9 The Appendix is available o
borrowing less than their credit limit so as to www.aeaweb.org/aer/conten
buffer their consumption against adverse partial equilibrium model o
choice which features an amou
shocks. That is, there is some target level of
ing limit similar to that as
their net worth such that, if their actual net conditions under which precau
worth falls short of that target, the precautionaryrestrictive if the volatility i
saving motive might outweigh impatience, andamount observed in macroec
entrepreneurs will try to restore some assets, 10 The CES aggregate produ
aggregation difficult. Howev
borrowing less than the limit. Specifically, en-form Yf f 1 Y(z) dz equals Y,
trepreneurs might not hit the borrowing limit steady state. In what follows
after a sufficiently long run of positive shocks.
as Y,.

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forever. The equilibrium is an allocation { h, h',

where At,k = 3(c/c'+ k) is the patient household
relevant discount factor and Xt is the markup,L,, L', Yt, c,, c', bt, bl}lo0 together with the
which in steady state equals X = e/(e - 1). This
sequence of values { w, Rt, P,, P,* Xt, A,, qt,} =
condition states that P* equates expected dis-satisfying equations (2) to (13) and the market
counted marginal revenue to expected dis-
clearing conditions for labor (Lt = L,), real
estate (h, + h' = H), goods (c, + c' = Yt), and
counted marginal cost. Profits Ft = (1 - 1/X,)Yt
are finally rebated to patient households.
loans (b, + b; = 0), given {ht-1, R,-1, bt-1,
As a fraction 0 of prices stays unchanged, the
Pt-1} and the sequence of monetary shocks
aggregate price level evolution is {eR,t}, together with the relevant transversality
conditions.
(12) P, = (OP _1 + (1 - 0)(Pt)l -e)ll(1 -). Appendix A describes the steady state. Let
hatted variables denote percent changes from
Combining (11) and (12) and linearizingthe steady state, and those without subscript
denote steady-state values. The model can be
yields a forward-looking Phillips curve, which
reduced to the following linearized system
states that inflation depends positively on ex-
pected inflation and negatively on the markup(which
X, I solve numerically using the methods
of final over intermediate goods. described by Harald Uhlig, 1999):
D. Central Bank Policy and the Interest Rate

Rule
(L1) V, = (c/Y) ^, + (c'/Y)6 ^
(L2) c t = E+ -
The central bank makes lump sum transfers
of money to the real sector to implement a
(L3) ce, = bb, + Rb(, - R, 1- 1)
Taylor-type interest rate rule. The rule takes the
form
+ (vY/X)(f',t - Xt) - qhAf,
(13) R, = (Rt,_ 1)rR(i+'t_"(Y,_ /y)rr )1 -rRe,t (L4) 4t = - eEtqt+1 +? (1 - Ye)Et

where Tr and Y are steady-state real rate and
output, respectively. Here, monetary policy re- tx (f+1 - h +1)
sponds systematically to past inflation and past
output.'1 If rR > 0, the rule allows for interest - mp3rr - (1 - mp3)EAt+,
rate inertia. eR,t is a white noise shock process
with zero mean and variance o2. (L5) t = EtqEt + + Lht + ' t- -EtC,+1
E. Equilibrium
(L6) b, = E,4,+ +1 +,- rrt
Absent shocks, the model has a unique sta-
tionary equilibrium in which entrepreneurs hit (L7) , = h
the borrowing constraint and borrow up to the q- (1 -v) -
limit, making the interest payments on the debt 1-v
and rolling the steady-state stock of debt over
- X- (1 - C)
" A backward-looking Taylor rule has the advantage of
isolating in a neat way the exogenous component of mon-
(L8) 7rt = OEt,+ 1- KXt
etary policy from its endogenous counterpart. As will be
shown later, given that the interest rate is assumed to re- (L9) / = (1 - rR)((1 + r -1 + ryt
spond only with one lag to all other variables, it offers some
convenient zero restrictions when taking the model to the
data. Fuhrer (1997) shows that the data offer more support + rRR,- 1 +eR,t
for a backward rule than for a forward rule. Bennett Mc-
Callum (1999) has emphasized a related point, since output
and inflation data are reported with a lag and therefore
where = (1 - P)hlh', K (1 - 0)(1 - 30)/0,
cannot be known to the policymaker in the current quarter. e - mp + (1 - m)y, and r t -~ , - E,,t + is

86.175.184.196 on Sun, 13 Dec 2020 08:43:12 UTC
the plays(L1)
ex ante real rate. a role, too:is
as obligations
total are notoutput.
indexed, (L
the deflationhousehold
Euler equation for raises the cost of debt service, further
consumpt
(L3) depressing entrepreneurial
is the entrepreneurial flow consumption
of funds. and (L
and (L5) express the investment.
consumption/housing m
gin for entrepreneurs How and
big are these effects? Figure 2 provides
households, resp
tively. (L6) is the borrowing
a stylized answer for threeconstraint.
economies subject to
supply side includes the
the same shock,production
showing the total loss in outputfunc
(L7) (combined with following
labor a one-standard
market deviation increase
clearing)
the Phillips curve (0.29percent
(L8). on Finally,
a quarterly basis) of(L9) is
the interest t
rate.' The solid line illustrates the case when
monetary policy rule.
both collateral and debt deflation effects are
F. The Transmission Mechanism: Indexation shut off, so that only the interest rate channel
and Collateral Effects works (see Appendix B for the technical de-
tails): output falls by 3.33 percent. Here, the
The basic model shows the key links betweenoutput drop is mainly driven from intertemporal
substitution in consumption. The dashed line
the interest rate channel, the house price chan-
nel, and the debt deflation channel. I now focus
plots the response of output when the collateral
channel becomes operational: the decline in
on one standard deviation (as estimated in the
VAR) negative monetary shock; in the full
output is larger, and the total decline is 3.82
model, I will look at other disturbances, too,percent.
and Finally, in the starred line, both collat-
eral and debt deflation channels are at work:
will estimate some of the structural parameters
of the model. The parameters chosen here re- output falls by 4.42 percent.13
flect the estimates and the calibration of the full
model. III. The Full Model: Household and
The time period is one quarter. The entrepre- Entrepreneurial Debt

neurial "loan-to-value" ratio m is set to 0.89.
The basic model assumes that all mortgaged
The probability of not changing prices 0 is set to
0.75. The discount factors are 3 = 0.99 and yreal
= estate is used by firms. In reality, financ
frictions apply to both firms and households
0.98. I set the elasticity of output to real estate
v to 0.03. (With j = 0.1, this yields a steady
The previous section models entrepreneur
consumption, but lacks the descriptive realis
state value of h, the entrepreneurial asset share,
of 20 percent.) The household labor supply emphasized, for example, in the quote fro
schedule is assumed to be virtually flat: rq =
Tobin at the beginning of the paper. In additio
1.01. investment occurs in the form of real estate
For the Taylor rule, I set ry = 0, r, = 0.27,
transfers between agents, but net investment is
rR = 0.73. These are the parameters of an zero. Before taking the model to the data, I
extend it along two dimensions. On the one
estimated policy rule for the VAR period, with
the exception of ry, which is reset to zero.
hand, I add a constrained, impatient household
Imposing r, = 0 amplifies the financial accel-
sector, that ends up facing a binding borrowing
erator since the central bank does not intervene constraint in equilibrium. On the other, I allow
when output falls. However, it allows isolating variable capital investment for the entrepre-
the exogenous component of the reaction func-neurs. This allows a more realistic analysis of
tion from its endogenous component, while en- the impact of a various range of disturbances: in
suring determinacy of the rational expectations
equilibrium.
The transmission mechanism is simple: con-
12 The figure shows the cumulative drop in output after
sider a negative monetary shock. With sticky 40 quarters. This is approximately the horizon at which
prices, monetary actions affect the real rate, and output has returned to the baseline, so that the cumulative
its increase works by discouraging current con- impulse responses level off.
13 It would be tempting to rank the two effects. There is
sumption and hence output. The effect is rein-
no way of doing so, however. For instance, depending on
forced through the fall in housing prices, which how aggressive the central bank is on inflation, the debt
leads to lower borrowing and lower entrepre- deflation effect can be larger or smaller than the collateral
neurial housing investment. Debt deflation effect.

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-0.5 -*- Debt deflation and collateral effect
-1 No debt deflation (indexed debt), no collateral effect

- No debt deflation (indexed debt), collateral effect
-1.5 !
-2
-3
S-3.32
..... i -3.82
-4.5 4.42
0 5 10 15 20 25 30 35 40
FIGURE 2. TOTAL OUTPUT Loss IN RESPONSE TO A MONETARY SHOCK IN THE BASIC MODEL:
COMPARISON BETWEEN ALTERNATIVE MODELS
Notes: Ordinate: time horizon in quarters. Coordinate: percent deviation from initial steady
state.
symmetric for each agent: such a cost might

particular, I add inflation, technology, and taste
shocks. As before, a central bank and retailersproxy for transaction costs, conversion costs of
complete the model. residential housing into commercial housing
The problems of patient households, retailers, and vice versa, and so on. The remainder of the
and the central bank are unchanged. I considerproblem is unchanged: entrepreneurs maximize
therefore the slightly modified entrepreneurialEo 0=o -/log c,, where y < /3, subject to
problem and then move to impatient households. technology (14) and borrowing constraint (10),
as well as the flow of funds constraint:
A. Entrepreneurs
(15) Y,/X, + b, = c, + qAh, + R,_ b,_1/trt
Entrepreneurs produce the intermediate good
according to: + wtLt + w"L_+ I,
(14) Y, = A,Kt"_ h," _,L;a(l - - )L'(i - a)(I - - v) + e,t + +K,t.
where At is random. L' and L" are the patient The first-order conditions for this problem
and impatient household labor (a measures theare fairly standard and are reported in Appen-
dix A.
relative size of each group) and K is capital (that
depreciates at rate 6) created at the end of each
period. For both housing and variable capital, I B. Impatient Households
consider the possibility of adjustment costs:
capital installation entails a cost ?K,t = t/ Impatient households discount the future
more heavily than the patient ones. They choose
Kt - 6)2Kt- 1/(28), where It = Kt - (1 -
8) K,1. For housing, changing the stock entailsconsumption c" housing h" labor L (and
a cost ?e,t = ke(Ahtht -1)2qtht-1/2, which is money M'/P,) to maximize

86.175.184.196 on Sun, 13 Dec 2020 08:43:12 UTC
o0
moving to the estimation strategy, I present two
direct implications of the main model features
E0t=O
(P3")t(ln c"'+ j,ln h"- (L')'I/Tr which can replicate key dynamic correlations in
the data: the collateral effect allows pinning
down the elasticity of consumption to a housing
+ X In Mt'IPt)
preference shock; the nominal debt effect allows
where p" < p. Like for entrepreneurs, matching
this guar- the delayed response of output to an
inflation
antees an equilibrium in which impatient shock.
house-
holds will hit the borrowing constraint. Here,
the subscript under j, allows for random distur-
D. Collateral Effects and Effects on
bances to the marginal utility of housing, and,
Consumption of a Housing Price Shock
given that it directly affects housing demand,
offers a parsimonious way to assess theSeveral
macro commentators have expressed the
effects of an exogenous disturbance on housethat rising house prices have kept
consideration
prices.14 The flow of funds and the borrowing
consumption growth high throughout the 1990s.
limit are Case et al. (2001) find long-run elasticities of
consumption to housing prices of around 0.06
for a panel of U.S. states. Morris Davis and
(16) c + q,Ah + R,_ -b'"- 1/Tr,
Michael Palumbo (2001) estimate a long-run
t t t t-5h~ elasticity of consumption to housing wealth of
= b"+ w'L "+ T"- AM'",/P, - 0.08.
-,t These positive elasticities are hard to rec-
oncile with the traditional life-cycle model.
(17) b' s m"E,(q,., h' +n,.,Think lR,) about the simplest case, an exogenous
where (h, = Oh(Ah'ht"_ ,)2qthf_ increase in housing the
,/2 denotes prices. If the gains were
housing adjustment cost (an equallyanalogous
distributedterm
across the entire population,
also appears in the budget constraint ofthe
if all agents had the
same propensity to con-
patient households). The borrowing constraint
sume, and if all agents were to spend these gains
is consistent with standard lending on housing, total used
criteria wealth less housing wealth
in the mortgage market, which would limitremain unchanged, and so would the
the amount
lent to a fraction of the value of the asset. One demand for non-housing consumption. However,
can interpret the case m" = 0 as the limit situ-if liquidity-constrained households value current
ation when housing is not collateralizable at all,consumption a great deal, they may be able to
so that households are excluded from financial increase their borrowing and consumption more
markets. than proportionally when housing prices rise, so
Like for the entrepreneurs, the equations for that increases in prices might have positive ef-
consumption and housing choice (shown in Ap- fects on aggregate demand.
pendix A) hold with the addition of the multi- The mechanism described above is at work
plier associated with the borrowing restriction.15 in the paper, and it is straightforward in dem-
onstrating its ability to produce an empiri-
C. The Linearized Model cally plausible response of consumption to
housing price shocks. Figure 3 displays the
The equations describing the steady-state andimpulse response of consumption to a persis-
the linearized model are isomorphic to those of tent housing price increase, generated from a
the basic model and are in Appendix A. Before shock to the marginal rate of substitution j
between housing and consumption for all
households. Such an experiment offers a par-
simonious way to model any kind of distur-
14I assume that the disturbance to j, is common to both
impatient and patient households. This way, variations bance
in j, that shifts housing demand, such as
can also proxy for exogenous variations in, say, the taxtemporary
code tax advantages to housing invest-
that shift housing demand for all households. ment or a sudden increase in demand fuelled
15 The money demand condition is redundant under in-
byfor
terest rate control, so long as the central bank respects, optimistic consumer expectations. The pa-
rameters
each group, the equality between money injections and are those calibrated and estimated
transfers. using the method described in Section IV,

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HOUSE PRICES
1.5 -- -- ---- . .m=0, ..........

m"=0O m=0.45, m"=0.3
1 m=0.89, m"=0.55
CONSUMP90%iTON
0.5
04
-0.5.'
0 2 4 6 8 10
0.5 - ---------------____ _____
-0.5
0 2 4 6 8 10
FIGURE 3. RESPONSE OF AGGREGATE CONSUMPTION TO A HOUSING PRICE SHOCK: VARIOUS

VALUES OF m AND m"
Notes: Ordinate: time horizon in quarters. Coordinate: percent deviation from initial steady
state.
except that here I compute responses for sev- loan-to-value ratios of 89 percent for entre-
eral values of the loan-to-values m and m", preneurial loans and 55 percent for residential
and compare them with the impulse response loans, can generate responses of consumption
from a housing price shock in a VAR. (and income, as will be shown below) to a
The VAR is estimated from 1974Q1 to housing price shock that are not only qualita-
2003Q2 on quarterly data for the federal tively but also quantitatively in line with the
funds rate, log real housing prices, log realVAR estimates. In particular, the impact elas-
personal consumption expenditures, log real ticity of consumption to a persistent 1-percent
GDP, and log change in the GDP deflator, inincrease in housing prices is around 0.2. This
that order.16 The figure illustrates an impor- is slightly larger than reduced-form estimates
tant point: the greater the importance of col- found in the studies above; however, both in
lateral effects (higher m and m"), the closerthe model and in the VAR, consumption falls
the simulated elasticity of consumption to abelow the baseline during the transition,
housing price shock. A wage share of the hence the medium-run elasticities are some-
constrained sector (1 - a) of 36 percent, and what smaller. Instead, the model without collat-
eral effects (m, m" -> 0) predicts a negative
response of consumption to housing prices-
mainly driven by a substitution effect between
16 Consistent with the theoretical model, I allow for all
housing and consumption-which is clearly at
the variables (except the interest rate) to respond contem-
odds with the data.
poraneously to a housing price shock. The results were,
however, robust to alternative orderings. The lags and theWhile I will conduct more formal estima-
set of exogenous variables are the same as in the VAR of
tion and testing below, this pictures highlights
Section I. Consumption, GDP, and house prices were de-
the reason behind the success of the model in
trended with a band-pass filter-removing frequencies above
32 quarters. tracking down the empirical positive elastic-

86.175.184.196 on Sun, 13 Dec 2020 08:43:12 UTC
INFLATION
1.5
nominal debt
SVAR90%
0 2 4 6 8 10
OUTPUT
2- ; --------. ........- .
2 1
-4
0 1 2 3 4 5 6 8 9 10
FIGURE 4. RESPONSE OF OUTPUT TO AN INFLATION SHOCK: NOMINAL VERSUS INDEXED DEBT
Notes: Ordinate: time horizon in quarters. Coordinate: percent deviation from initial steady state.
ity of spending to housing prices. I'o betterchanges in q, can be rather large, and is
understand the result, it is useful to reinterpretstrongly increasing with m, the loan-to-value
the borrowers' asset demand as determiningratio. Instead, as shown by equation (L5), for
consumption given asset prices and payoffs,lenders the effects of q, on c, are simply
one-for-one, and therefore much smaller in
rather than determining today's asset prices
in terms of consumption and payoffs. For magnitude.
entrepreneurs, for instance, the linearized op-
timality condition between housing and E. Debt Deflation and the Stabilizing Effects
consumption can be written (neglecting ad- of an Inflation Shock
justment costs) as
Starting from the steady state, I assume a
1 1-percent, persistent inflation surprise.17 It
(18) , = Etct + 1 m is informative to contrast the response of
output with nominal debt to the model with in-
dexed debt. Figure 4 displays the results of the
X ( A - YeEtqt+,, - (1 - ye)E,,t+ )
simulation.
With nominal debt (the solid line), the rise in
mp
+ rr m prices reduces the desired supply of goods at a
1 - m3r
where Ye - mp + (1 - m)y and E,St,, is

the expected marginal product of housing. 17 The inflation shock shows up as a residual in
This equation clearly shows how, keeping the Phillips curve. It could be justified by assuming
that the elasticity of demand for each intermediate
constant expected consumption, expected re- good is time-varying, and varies exogenously, as
turns on housing, and real interest rates, the done, for instance, by Frank Smets and Rafael Wouters
multiplier effect on consumption of given (2003).

86.175.184.196 on Sun, 13 Dec 2020 08:43:12 UTC
Next, I set y and P". I match the reciprocal of

given price level; at the same time, it transfers
wealth from the lenders toward the borrowers,y, which proxies for the firm's internal rate of
return. I assume this is twice as big as the
who, ceteris paribus, have a higher propensity
to consume. Initially, the two effects go in equilibrium
op- real rate, and set y = 0.98. I then
pick a value for P": Emily Lawrance (1991)
posite directions, and output falls by a small
amount. Later, the first effect dominates, and estimates discount factors for poor households
the output drop is larger: overall, output dis- (which are more likely to be debtors) between
plays a hump-shaped pattern and a slow return 0.95 and 0.98 at quarterly frequency, depending
to its initial steady state. on the specification. Carroll and Andrew Sam-
This contrasts with the responses that would wick (1997) calculate an empirical distribution
occur in a model without debt deflation effects of discount factors for all agents using informa-
(the dashed line): with indexed debt, the drop intion on the elasticity of assets with respect to
output is immediate and stronger in magnitude,uncertainty: the two standard deviation bands
because the beneficial effects of inflation are range in the interval (0.91, 0.99). Samwick
absent. Hence, the assumption of nominal debt(1998) uses wealth holdings at different ages to
helps capture not only qualitatively but also
infer the underlying distribution of discount fac-
quantitatively the hump-shaped and persistenttors: for about 70 percent of the households, he
finds mean discount factors of about 0.99; for
response of output to inflation found in the VAR.
about 25 percent of households, he estimates
Interestingly, the negative correlation be-
discount factors below 0.95. With P set at 0.99,
tween inflation and output induced by an infla-
tion shock acts as a built-in stabilizer for the I choose 3" = 0.95, in the ballpark of these
economy. Debt deflation thus adds a new twist estimates.
to the theories of financial accelerator men- I set v, the elasticity of output to entrepre-
tioned in the introduction: while it amplifiesneurial real estate, to 0.03. This number implies
a plausible 62 percent for the steady-state value
demand-type disturbances, it can stabilize those
that generate a trade-off between output of andcommercial real estate over annual output.
inflation. I will return to this issue in Section VI. The parameter j mainly controls the stock of
residential housing over annual output (see Ap-
IV. Econometric Methodology pendix A): j = 0.1 fixes this ratio at 140 percent,
in line with data from the Flow of Funds ac-
I now discuss the methodology for evaluating counts (see, e.g., Table B.100, row 4).
the model. I partition the model parameters in I then pick values for the adjustment cost
three groups. parameters. Preliminary attempts to estimate
these parameters (using the methods described
A. Calibration in Section IV C) led to estimates of the capital
adjustment cost tp around 2 and pushed the
The first group includes the discount factors:
housing adjustment cost parameters 0e and bh
3, P", y; the housing weight j; the technologytoward zero. These results suggest that the data
appear to favor a version of the model in which
parameters i., v, 6, 40, 4 bh; the markup X; the
variable capital moves more slowly than hous-
labor disutility -q; and the degree of price rigid-
ingofin response to disturbances. Although this
ity 0. I calibrate these parameters on the basis
the data sample means and other studiesfinding
be- is not in contradiction to the cyclical
properties of the actual data,19 it is likely that
cause they contain relatively more information
on the first moments of the data.
For the standard parameters, I choose values
that are within the range considered in the mon-
studies would suggest, but has the virtue of rationalizing the
etary/real business cycle literature. Thus, 3, 6, weak observed response of real wages to macroeconomic
it, X, 0, and rl equal 0.99, 0.03, 0.3, 1.05, 0.75, disturbances. With q approaching 1, the utility function
and 1.01, respectively.18 becomes linear in leisure, as proposed and explained in
Gary Hansen (1985).
19 For the period 1974Q1-2003Q2, the standard devia-
tion of (a) structures investment, (b) residential investment,
(c) equipment and software investment, and (d) change in
18 A value of rl = 1.01 implies a virtually flat labor
inventories are, respectively, 0.8, 0.5, 0.58, and 0.94 per-
supply curve: this is higher than what microeconometric

86.175.184.196 on Sun, 13 Dec 2020 08:43:12 UTC
the solution algorithm has TABLEdifficulty

1-CALIBRATED PARAMETERS
inIN THE EXTENDED
estimat-
MODEL
ing these parameters without data on the types
of investment spending. At the same time, one
Description Parameter Value
has to consider that, ceteris paribus, the fixity of
Preferences:
the housing stock in the aggregateDiscount factors by
works
itself as an adjustment cost onhouseholds
Patient housing P invest-
0.99
Entrepreneurs
ment: given that the total y 0.98
supply of structures is
Impatient
fixed, additional housing households p3"
investment in0.95
any
given period drives up the
Other price
preferenceof the existing
parameters
stock, so that, from each agent's point of view,
Weight on housing services j 0.1
every unit of new investment is more costly at
Labor supply aversion 7 1.01
the margin. In what follows, therefore, I esti-
Technology: Factors
mate the model by calibrating qr = productivity
2 and 4e =
Oh = 0.20 The former implies an elasticity
Variable capital share 4 of
0.3 1/2
of investment to the capital
Housing shadowshare price,
v 0.03 fol-
lowing Robert King and Alex Wolman (1996):
this value is well withinOther
the range technology parameters
of estimates
Variable
reported in the literature (seecapital adjustment
Robert cost q, 2
Chirinko,
1993). Table 1 summarizesVariable
thecapital depreciation rate 8 0.03
parameters.
Housing adjustment cost 0
B. Policy Rule Sticky prices
Steady-state gross markup X 1.05

The second group includes the
Probability parameters
fixed price 0 0.75
that can be recovered from the estimates of the
Taylor rule. For the period 1974Q1-2003Q2, an
OLS regression of the Fed Funds
eters rate on
by minimizing its own
a measure of the di
lag, past inflation, and between
detrended output yields
the empirical impulse responses
rR = 0.73, ry = 0.13, r,
tion=I) 0.27.21
and the model responses, which
obtained from the reduced form of the m
C. Estimation ordering and orthogonalizing the shocks
the VAR.
The third group includes the autocorrelation As is well known (see, e.g., Ireland, 2004a),
and the standard deviation of each shock (PA, pj,the number of data series in the VAR represen-
Pu,, oa, o ou), the loan-to-value ratios (m, m"), tation cannot exceed the number of structural
and the wage income share of the patient house-disturbances in the model. With four distur-
holds, measured by a. I estimate these param- bances (monetary, inflation, taste, productivity),
I select (R, 7r, q, Y) as the variables of interest.
Denote with I(t) the vector collecting the
cent. (All variables were normalized by GDP. The data weremodel orthogonalized impulse responses, ob-
then filtered using a band-pass filter that removed the low-
tained from the reduced form of the model by
frequency component above 32 quarters.)
20 The results with be, Oh > 0 are qualitatively as fol-
ordering and orthogonalizing the impulse re-
lows: housing adjustment costs reduce the fluctuations in sponses as in the VAR. Let 9lt be the n X 1
the housing stock variables but generate slightly largervector of empirical estimates of the VAR im-
changes in housing prices and output, which the data appearpulse responses.22 I include the first 20 elements
to reject. Closer inspection of the impulse responses shows
of each impulse response function, excluding
that, when facing costs of adjusting both k and h, entrepre-
neurs vary labor input more strongly in response to distur-those that are zero by the recursiveness assump-
bances, which in turn affects output.
21 The standard deviation of the monetary shock o-e is
taken from the standard error of the interest rate equation in
the VAR below, which equals 0.29. In principle, one could 22 n = n n2 - n3, where n1 is the number of variables
also obtain all the parameters of a more involved policy rulein the VAR, n2 are the elements to match for each impulse
from the VAR. I use a shift dummy from 1979Q4 to captureresponse, and n3 are the elements of T which are zero by
monetary policy changes that are known to have occurredassumption (because of the zeros imposed by the Choleski
around that time. ordering).

86.175.184.196 on Sun, 13 Dec 2020 08:43:12 UTC
TABLE 2-ESTIMATED PARAMETERS AND THEIR STANDARD

their wage share (1 - a) is around 36 percent
ERRORS IN THE EXTENDED MODEL
and is precisely estimated:24 interestingly, this
number is within the range of the various stud-
Description Parameter Value s.e.
ies that, since Campbell and Mankiw (1989),
Factor shares and loan-to-values
have estimated from consumption Euler equa-
Patient households wage share a 0.64 0.03 tions the fraction of rule-of-thumb/constrained
Loan-to-value entrepreneur m 0.89 0.02 agents in an economy. At the same time, they
Loan-to-value household m" 0.55 0.09
support strong effects on demand from changes
Autocorrelation of shocks in asset values, as shown by the high values of
m and m". The former is 89 percent, whereas the
Inflation Pu 0.59 0.06 latter is 55 percent. Hence, the estimates suggest
Housing preference pj 0.85 0.02
Technology PA 0.03 0.10 that entrepreneurial real estate is more easily
collateralizable than household real estate. A
Standard deviation of shocks joint test of the hypothesis that collateral con-
Inflation ou, 0.17 0.03 straints are unimportant-that the m and m" are
Housing preference oj 24.89 3.34 equal to zero--is overwhelmingly rejected.
Technology o-a 2.24 0.24 High values of m and m" are in fact needed to
generate strong and persistent effects on aggre-
gate demand from given changes in asset val-
ues, something that a model without these
tion. The estimate of ?, a vector of parameters,
solves effects cannot replicate.
Finally, the estimate of the autocorrelation in
(19) min(1I(()- W)'F(I(() - I) the technology shock is low (PA = 0.03) and
less precisely estimated: one explanation might
be the detrending method used in the VAR,
where D is a n x n weighting matrix. Under the which takes away the low-frequency compo-
null hypothesis that the VAR model is true and nent of GDP. Instead, the autocorrelations in the
that the model fits the data, the optimal weight- preference and in the inflation shock are pre-
ing matrix D would equal D = Y-1, the inverse cisely estimated and highlight moderate persis-
of the matrix with the sample variances of the
tence in the shock processes (pj = 0.85, P, =
VAR impulse responses on the main diagonal. 0.59). Interestingly, such autocorrelations are
Given that the cross-correlations between q and lower than what is found in estimates of stan-
Y are likely to be relatively more informative for dard monetary business cycle models: one pos-
m, m", and a, I specify D = lY-', where 11 is sibility is that the endogenous propagation
a n X n diagonal matrix of weights that gives a mechanisms that are at work in the model re-
weight four times larger to all the dynamic quire less persistent shocks to fit the second
cross-correlations involving q and Y. This way, moment properties of the data.
I still get consistent (yet inefficient) estimates of While the estimates of a, m, and m" are all
all the parameters, but at the same time I fit the statistically significant,25 I reject the null
moments of highest interest.23 The results were,
however, robust to the choice of fn.
Table 2 summarizes the estimates of the pa- 24 Standard errors were computed using the asymptotic
rameters in ?. The results strongly support the delta function method applied to the first-order condition
presence of borrowing-constrained households: associated with the minimization problem.
25 These findings are robust to changes in the estimation
horizon and in the weighting matrix. As a robustness check,
I included the discount factors among the parameters to
23 As suggested by a referee, housing collateral is inter-estimate. The resulting values for /3" and y were, respec-
esting because of the potential spillovers to other consump-tively, around 0.4 and 0.9; the other parameter estimates
tion goods as housing price increases relax borrowingwere unchanged, with the exception of m", whose estimate
constraints. By focusing on the parameters that best matchwas marginally positive. Loosely speaking, a reduction in
the dynamic cross-correlation between house prices and the discount factor works to strengthen the preference for
output (and therefore consumption), the estimation proce- current consumption, thus working in the same direction as
dure selects these particular moments as most informative at an increase in the loan-to-value when it comes to explaining
the margin for the values of m, m", and a. the high sensitivity of demand to aggregate shocks. How-

86.175.184.196 on Sun, 13 Dec 2020 08:43:12 UTC
response of R response of x response of q response of Y

r 0.4 0.4 2 2
1 0.2 0.2 1 1
0 10 20 0 10 20 0 10 20 0 10 20
S0.4 0.4 2 2
2 0.2 0.2 1 1
0O0
00
S-0.2 -0.2
0 10 20 0 10 20 0 10 20 0 10 20
S0.2 0.2 1 1
u o
-0.2 -1
-0.2 -1
0 10 20 0 10 20 0 10 20 0 10 20
>- 0.4 0.4 2 2
0
0 0 0
0.21 0
1
-0.2 oxa"-
-0.2 -1 -1
0 10 20 0 10 20 0 10 20 0 10 20
quarters quarters quarters quarters

FIGURE 5. RESPONSES TO ALL SHOCKS, MODEL VERSUS VAR
Note: Coordinate, percent deviation from steady state. Solid lines: estimated model.
bands.
hypothesis of equality between the model and V. More on the Model Dynamics
the data. Perhaps the simplest explanation for
this finding is that the model lacks such features Figure 5 shows the model impulse responses
as expectational delays, inertial adjustment of and compares them with the VAR impulse re-
prices, or habit persistence, which elsewhere sponses. This way, I can assess the key proper-
authors have shown can help replicate the de- ties of the model and its consistency with
layed responses of macroeconomic variables to empirical evidence.26
various shocks (see, e.g., Julio Rotemberg and The top row shows a monetary tightening.
Michael Woodford, 1997; Gall and Gertler,
1999; Fuhrer, 2000).
26 One caveat: the impulse responses from the VAR and
those from the structural model are not strictly comparable,
since the restrictions implied by the two representations are,
ever, although empirical estimates of the discount factor arein general, different. See Fuhrer (2000) for a discussion: an
surrounded by large uncertainty, values below 0.9 appearalternative could be to compare the autocorrelation func-
too low to be considered reasonable (see Carroll and Sam-tions implied by the various models. The results using this
wick, 1997). representation were qualitatively similar.

86.175.184.196 on Sun, 13 Dec 2020 08:43:12 UTC
The drop in output is immediate in the model, transmission mechanism: rather, it is the general
equilibrium effects working through the de-
while it is delayed in the data, although the total
output sacrifice is in line with the VAR esti-mand for all factors of production that affect the
mate. As in the basic model, money shocks have aggregate outcomes.28
heterogeneous effects: debtors bear most of the
brunt of the monetary contraction, while con- VI. Systematic Monetary Policy and Policy
sumption of lenders is mildly affected and can Frontiers
be shown to rise above the baseline in the tran-
sition to the steady state. In turn, the real rate, Shocks that generate a negative correlation be-
which prices lenders' behavior, falls below the tween output and inflation force the central bank
baseline in the transition. Real housing pricesto face a trade-off between the variability of out-
initially fall below the baseline, deepening the put and that of inflation. A natural question is:
recession, and then overshoot above the base- how do different monetary policy rules and con-
line, preceding the economy's recovery. tractual arrangements affect the cyclical properties
The previous section has already shown how of output and inflation? This section gives an
nominal debt is successful in capturing the slug-answer, based on the assumption that output and
gish response of output to an inflation shock. inflation volatility are the only two goals of mon-
The second row of Figure 5 shows that the modeletary policy. I consider whether interest rates
does very well at capturing the positive responseshould respond to housing prices; and how differ-
of the interest rate and the negative response of ent financing arrangements (nominal versus in-
housing prices to an inflation surprise. dexed debt) affect the volatility of the economy.
For the preference shock, the third row of
Figure 5 shows that the model does well in A. Should Central Banks Respond to Housing
capturing the positive elasticities of demand and Prices?
inflation to a housing price shock. Figure 3 has
already shown how a model without collateral I compute the inflation-output volatility fron-
effects predicts a small, even negative, responsetiers for alternative parameterizations of the in-
of aggregate demand to a housing price shock.27terest rate rule, as in Andrew Levin et al.
The last row of Figure 5 shows the responses(1999), subject to a constraint on interest rate
to a transitory productivity rise. Here it is hardervolatility.29 The class of rules I consider is
to compare the responses of the model with the
data, especially because it is harder to consider (20) , =0.73A,_1
the VAR disturbance as a pure productivity
shock: for instance, a government spending
+ 0.27(rq-t, + (1 + r,)rt-1 + ryrY -t).
shock could be observationally equivalent. In the
model, output and asset prices peak only with a In other words, I assume that the central bank
delay following the improvement in productivity. can respond to current asset price movements:
In simulations not reported here, I find that
the model predicts a standard deviation for en-
trepreneurial housing investment that is twice 28 One drawback of the model is that it predicts that
that of variable capital investment: this numberhouseholds' housing holdings are countercyclical: with a
fixed supply, this sector absorbs in fact the reduction in the
is slightly bigger but roughly in line with thedemand by the entrepreneurs. This need not be unrealistic if
data (see footnote 19). Not shown in figure, housing
I is given a broad interpretation, which also includes
find that in response to, say, a negative mone-land. In Japan, for instance, households and the government
tary shock (positive preference shock), h falls have traditionally been net purchasers of land in periods of
falling land prices (see the 2003 Annual Report on National
(rises) on impact by 4 percent (3 percent).
Accounts of Japan).
Given that the elasticity of output to real estate 291 compute the Taylor curves tracing out the minimum
is very small (0.03), this shows that changes inweighted unconditional variances of output and inflation at
housing ownership per se are not crucial to thedifferent relative preferences for inflation versus output
variance. I constrain interest rate volatility by imposing an
upper bound 25 percent larger than the estimated standard
deviation generated by the benchmark model. I also impose
27 Given the adjustment cost for capital, the initial re- r,, r, > 0 to generate a unique rational expectations equi-
sponse of output is roughly equal to that of consumption. librium for each policy.

86.175.184.196 on Sun, 13 Dec 2020 08:43:12 UTC
3
- r =0
q
...... r >0
2.5 q
0 2
1.5
0.5
0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
standard deviation of a
FIGURE 6. POLICY FRONTIERS AND ASSET PRICE RESPONSES
Note: The triangle indicates the performance of the rule estimated for the period 1974Q1-
2003Q2.
this way, I shift the bias in favor of finding a The unimportance of responding to asset
non-zero coefficient on asset prices in the reac-prices is reminiscent of the findings of Bernanke
tion function. and Gertler (2001) and Simon Gilchrist and
I compute two efficient frontiers. In the firstJohn Leahy (2002). They look at whether cen-
one, I fix rq = 0; in the second, I allow R, to tral banks should respond to stock prices in a
respond to qt. This way, I investigate the extentversion of the Bernanke et al. (1999) model
which allows for fundamental and nonfunda-
to which responding to asset prices can yield
lower output and inflation volatility. Altogether,mental asset price changes. They find no case
responding to asset prices does not yield signif-for responding to stock prices, although they do
icant gains in terms of output and inflation sta-not calculate a complete efficient frontier for
bilization. As shown by Figure 6, the frontier different policy rule specifications. In their
obtained by responding to asset prices shiftssetup, the signal-to-noise ratio of asset prices is
inward only marginally: keeping inflation stan-too low for asset prices to be informative for the
dard deviation constant, the decrease in the central bank. Here, asset prices matter in that
standard deviation of output is a rather small they transmit and amplify a range of distur-
number, about 0.7 percent of its baseline value. bances to the real sector. Despite this, if the
The optimal rq is positive and slightly increas- central bank wants to minimize output and
ing in the weight given to output stabilization in inflation fluctuations, little is gained by re-
the loss function, ranging between 0.1 and 0.15. sponding to asset prices, even if their current
However, such a weight is small compared to movements are in the policymaker information
the optimal responses to output and inflation.30 set.
30 The "optimal" coefficients on output and inflation are

larger than those estimated from the historical rule. If the respectively. For this reason, the estimated policy rule in-
relative weight on output stabilization is around, say, 10 dicated in the figure performs worse than the optimal two-
percent, the optimal r, and ry should be around 4 and 1.5, parameter rule for the model.

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----- nominal debt

indexed debt
2.5
o2 2
1.5
0.5
0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

standard deviation of ,
FIGURE 7. POLICY FRONTIERS: NOMINAL VERSUS INDEXED DEBT
Note: The triangle indicates the performance of the rule estimated for the period 1974Q1-
2003Q2.
B. Does Debt Indexation Reduce Economic gives more leverage to the central bank, and im-
Volatility ? plies that smaller interest rate changes are needed
to stabilize the economy for given demand
As shown earlier, the model can deliver a disturbance.
sAnaller response of output to monetary shocks It is interesting to consider how the results
when debt contracts can be indexed to the price change when the trade-off involves inflation and
level, but indexed debt does not dampen output output gap, defined as the shortfall of output from
responses to inflation or technology shocks. Con- its equilibrium level under flexible prices (as prox-
sider a positive inflation surprise: this shock ied by X,, the time-varying markup). The main
causes a stronger output decline in the indexed difference with the baseline case concerns tech-
debt model since, while demand drops in both nology shocks. Consider, say, a favorable technol-
cases, borrowers do not get the benefit of lower ogy shock: for a given drop in prices, output rises
real repayments as before. Hence, indexed debt less with nominal debt than with indexed debt
stabilizes only the type of disturbances that mon- because of the negative deflation effect; however,
etary policy can offset. In the presence of "supply" output gap rises more with nominal debt than with
shocks, the Taylor curve in an economy with indexed debt because, while in both cases down-
ward price stickiness prevents aggregate demand
indexed debt lies above that for an economy with
nominal debt (Figure 7). This result is somewhat
from rising enough to meet the higher supply,
surprising and goes counter the widely held wis-
debt-deflation implies that demand rises even less
if debt is not indexed. Hence the gap is bigger
dom that high levels of household and firm debt
may threaten economic stability. However, it is a
under nominal debt and, if the technology shocks
natural consequence of two causes: first, the were the only source of supply-side fluctuations,
shocks that matter for the trade-off are only those the trade-off would be worsened under nominal
that move the target variables in opposite direc- debt. Quantitatively, whether nominal debt is
tions; second, the accelerator of demand shocks better than indexed debt depends on the relative

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3.4
- nominal debt
3.38 - -. indexed debt
x
0 - 3.36
. 3.34
- 3.32
S3.3
3.28
3.26
0.2 0.22 0.24 0.26 0.28 0.3 0.32 0.34
standard deviation of u
FIGURE 8. POLICY FRONTIERS WITH OUTPUT GAP: NOMINAL VERSUS INDEXED DEBT
standard deviation of inflation versus technologymatch the positive response of real spending to a
shocks and on the policymaker's preferences.31 housing price shock. Second, nominal debt allows
Figure 8 shows the two Taylor curves in outputthe model to accurately replicate the sluggish dy-
gap/inflation standard deviation space: if the namics of real spending to an inflation surprise.32
weight on inflation stabilization is large, the cen- Given that the model is quite successful in
tral bank can offset technology shocks better than matching some key properties of the data, one
inflation shocks, and nominal debt dominates in-can conduct quantitative policy analysis. In par-
dexed debt. If the weight on output stabilization isticular, I show how the fact that debt-deflation
large, the reverse is true, and indexed debt yields amplifies demand shocks but stabilizes supply
a better trade-off. shocks yields an improved output-inflation vari-
ance trade-off for the central bank. I also show
VII. Concluding Remarks that responding to asset prices does not yield
significant welfare gains.
My model adds two important dimensions to One limitation of the model is that it rules out
the literature on financial frictions and the mac- buffer-stock behavior: key to this result is that
roeconomy: (a) nominal debt contracts, and (b) aggregate uncertainty is small relative to the
collateral constraints tied to housing values on degree of impatience of borrowers. In Appen-
both the firm and the household side. It then takes dix C,33 I investigate this issue in a partial
them to the data. The improvements afforded byequilibrium model of consumption and housing
these features arise in two important and distinct investment with borrowing constraints that fea-
ways. First, collateral effects allow the model to
32 In a variant of the model developed by Bernanke et al.

31 In practice, a large response of the interest rate to the (1999) calibrated to U.K. data, Kosuke Aoki et al. (2004)
gap would stabilize the gap itself as well as inflation, but assess the impact of monetary policy on the real economy
might violate the volatility bound on the interest rate: how- through its effect on consumption and housing prices. They
ever, this could not hold under cost-push shocks, which fall short, however, of providing a full analysis of the
would require either keeping inflation constant (but a large interactions between house prices and the macroeconomy.
variance in the gap) or keeping the gap constant (but a large 33 The Appendix is available on the AER Web site
variance in inflation). (http://www.aeaweb.org/aer/contents).

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tures an amount of uncertainty sufficient toisrep-

needed to replicate the actual data. While
licate the aggregate output volatility in thethese
data.results are suggestive, ideally one would
The nonlinear solution shows how such uncer- like to embed this extension in a full-blown
general equilibrium model which endogenizes
tainty is small enough to generate nonnegligible
quantities as well prices, and which introduces
buffer-stock behavior. In particular, agents bor-
row up to the limit in all states unless the idiosyncratic risk in addition to aggregate risk.
standard deviation of the underlying aggregate Assessing this is an important task for future
shock rises to about four times more than what research.34
APPENDIX A: STEADY STATE AND LOG-LINEARIZATIONS
Steady State of the Basic Model. Assuming zero inflation (so that R = 1/3), the steady state will
be described by
h yv(l - 3)
H yv(l - P) + j((X - v)(1 - ye)
qh yv 1
Y 1- ye X
b /myv 1
Y 1 - Ye X
c v qh (1 - y)(1 - m)1
- = (I 1- )mn
c' X - v qh yv(1 - P))m

-=X-v
CY - +Yh(1 - -P)m
1,,y Te Xl Y = (X-V
where Ye - (1 - m)y + m/ is the average discount factor for the returns to entrepreneu
estate investment.
The Impatient Household Problem in the Extended Model. Denoting with h" the multiplier on th
borrowing constraint, the first-order conditions are
1 P"Rt,
St"= Et Rt 'R,
Ct t+1Ct+1
c" q ht_
I1 'hh"i = c,11
+ O h-
hitE? ,,
3qt+1 + ,Ah"it
1 + h
h, + h "t q+ t
w"f/c"
t t t = (L") -i
34 Carroll and Dunn (1997) develop a dy

purchases with idiosyncratic and aggrega
housing and transaction costs, can explain
does not have idiosyncratic risk, assumes t
these differences, my model also predicts t
may account for the increased sensitivity

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The Entrepreneurial Problem in the Extend
v=t - - K 2 8 +Ett +
w= a(1 - - v)Yt/(X,L')
w"= (1 - a)(l - g- v)Yt/(X,L')
where vt = (1/ct){ (1 + (tI/8)[(IIK,K_ 1) - 8]), tog
the adjustment cost terms.
The first equation says that the shadow price o
next period plus the capital contribution to low
in the next period. In addition, there are two
Steady State of the Extended Model. The val

over output (qhlY and blY) are unchanged
1)/X,
estate s"
shares for each - (1 -
household are a)(1 - I - v)/X be the income sha
qh'
- =j jmyv
s' + 1 j
+4 m"s"
Y 1 - p 1 - re X 1 - P" - m"(P - A" - j(1 - p))
qh" j
Y = 1 - " - m"(P
The debt-to-output and th
b" jpm"
Y 1 - o" - m"(3 - 13") +
c" 1 - P" - m"( - P")

Y 1 - p" - m"(p - -") + jm"(l - 0)
The consumption-to-output ratio for the entrepreneurs is
c Sy_ (1 - P)myv 1
Y O =-1) - -Ye
1-y1-8 , X'
The Complete Log-Linearized Model. To sa

variables dated t + 1, which must be inte
available at time t. The model can be expr
1. Aggregate demand
c c' c" I ,
(A1) Yt = y tY t Y t Y
(A2) ct = '+I - rt
1 - y(1 - 8) 1
q, qs

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2. Housing/consumption margin
(A4) q, = Yet+i + (1 - ye)(;t+ 1 - St - I,) - mprh, - (1 - mp)Aht+l

-Oe (Aht y/i+)
(A5) t, = Yht+h 1 (1 - Yh)(jt- f7) -0 m"t?(t + (1 m"+3)( W- eo'+1)
- h( Ah'- i. " t'I + 1)
(A6) qt = Bt,+ + (1 - P)j, + Lt, + -"- "+ 8' - p, [t
+ (hA, + h"Ah'f"- phAfi,+1 - ph"AIh" )

h, fh,+
3. Borrowing constraints
(A7) t, = qt- + + 4,
(A8) ' = +1 + fi't- rt
4. Aggregate supply
^=Ap1- v- (X
(A9) t-= (A + vl - If+ t _ 1) - --(, +
(59 4= - (1 - v-1 t-,-) - (1 - g)
(A10) 'rt = 1-- KXt +" att
5. Flows of funds/evolution of state variables
(All) K, = , + (1 - ) 1
b c qh IA Rb
(A12) - - - A, + -IY ( -1
b" c" qh" Rb"
(A13) Y Ai+ ( --1 "+ t-1 - , ) - s(t
6. Monetary policy rule and shock processes
(A14) R?, = (1 - rR)(l + r,)rtl + ry(l - r)Yt-1 + r

jt = PjIt-1 + e,t
Ut = Putr-I+ eu,t
At = PAAt - 1 + eA,t

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where to = (/" - m"3")I(1 - m"P), L = (1
and
(Al)rr, - , -
is the E,,+ market
goods +1 is the ex ante (A2)
clearing. real
consumption. (A3) is the investment sched
sumption/housing is (A4), the impatient h
(incorporating market clearing) is (A6) (the
cost). The borrowing constraint for firms
function together with labor market clear
for capital. (A12) and (A13) describe the
households, respectively. (A14) is the mone
stochastic AR(1) processes for preferences,
APPENDIX B: ALTERNATIVE MODELIN
Indexed Debt. If debt is indexed to the pri
realized
flow real value
of funds of his
becomes debt, that is, R,_ I(P/P,_ 1)B,-. In the basic model, the entrepreneurial
Y,/X, + b, = c, + q,Ah, + R, -b, _1 + w'L,.

The entrepreneurial new Euler equation is
1/c, = yE,(R,/c,t1) + A,R,

whereas the Euler equation for the unconstrained households is
1/c' = PE,(R,/c', )
so that now lenders' behavior prices nominal bonds.
No Asset Price Channel. The borrowing limit is B, = PB/R, where BIR is a constant independent
from the asset value. The first-order conditions for consumption and housing choice become
1 R,
- = (yE ? + AtR
ct t+1 t + I Ct+
CctqtCt=yEt
+ 1 A/,
Xt++Iht
qt .+
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House Prices, Borrowing Constraints, and Monetary Policy in the Business Cycle

Author(s): Matteo Iacoviello

Stable URL: https://www.jstor.org/stable/4132738

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While these studiesitive

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response of R response of t response of q response of Y

2*A 0.2 0.2 1 1

" -0.2 -0.2

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parameters of the extended

(a) A negative response of nominal

(c) A positive comovement of asset prices

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retailers (described below), and the last two b, ? mEt(qt+ hrt+1/Rt).

tion. Since I focus in what follows on interest

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1 yRt sults. In the paper, I take as given that

To motivate sticky prices I assume implicit

(p - y)/c > 0. Therefore, the borrowing con-

(10) bt = mEt(q,., hrt, + IIRt). 0 P*(Z) X

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forever. The equilibrium is an allocation { h, h',

D. Central Bank Policy and the Interest Rate

(13) R, = (Rt,_ 1)rR(i+'t_"(Y,_ /y)rr )1 -rRe,t (L4) 4t = - eEtqt+1 +? (1 - Ye)Et

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The time period is one quarter. The entrepre- Entrepreneurial Debt

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-0.5 -*- Debt deflation and collateral effect

-1 No debt deflation (indexed debt), no collateral effect

symmetric for each agent: such a cost might

(14) Y, = A,Kt"_ h," _,L;a(l - - )L'(i - a)(I - - v) + e,t + +K,t.

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1.5 -- -- ---- . .m=0, ..........

0.5 - ---------------____ _____

FIGURE 3. RESPONSE OF AGGREGATE CONSUMPTION TO A HOUSING PRICE SHOCK: VARIOUS

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FIGURE 4. RESPONSE OF OUTPUT TO AN INFLATION SHOCK: NOMINAL VERSUS INDEXED DEBT

where Ye - mp + (1 - m)y and E,St,, is

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Next, I set y and P". I match the reciprocal of

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the solution algorithm has TABLEdifficulty

B. Policy Rule Sticky prices

Steady-state gross markup X 1.05

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TABLE 2-ESTIMATED PARAMETERS AND THEIR STANDARD

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response of R response of x response of q response of Y

quarters quarters quarters quarters

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FIGURE 6. POLICY FRONTIERS AND ASSET PRICE RESPONSES

30 The "optimal" coefficients on output and inflation are

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----- nominal debt

0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

FIGURE 7. POLICY FRONTIERS: NOMINAL VERSUS INDEXED DEBT

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3.38 - -. indexed debt

32 In a variant of the model developed by Bernanke et al.

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0.5 - --------------- _