Land price dynamics and macroeconomic fluctuations with imperfect substitution in real estate markets

The collateral channel, whereby an increase in residential house prices leads to an increase in commercial property prices, loosening firm borrowing constraints and increasing firm investment, is weaker when residential and commercial real estate are imperfect substitutes. We enrich the DSGE model of the collateral channel in Liu et al. (2013) by adding a land development sector to allow residential and commercial land to be imperfect substitutes. Bayesian estimation of our structural model based on aggregate U.S. data indicates imperfect substitution between the two types of land. With variance decompositions and impulse responses, we show that the strength of the collateral channel linking residential house prices and firm investment is weaker when the two types of land are imperfect substitutes. When residential and commercial land are assumed to be perfect substitutes, shocks to residential real estate demand explain 20–30% of the variance of output and 30–40% of the variance of investment, but with the imperfect degree of substitution that we estimate, the same shocks explain less than 10% of the variance of output and 12–15% of investment.