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'Real-world' mortgages, consumption volatility and the low inflation environment

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  • Sebastian Barnes
  • Gregory Thwaites

Abstract

This paper considers the interaction between the microeconomic decisions facing households and the macroeconomic environment in a setting where households have `real-world' mortgage contracts. In particular, we consider the possible consequences of the important changes in the framework for setting monetary policy in the United Kingdom in recent decades that have coincided with a more stable and low inflation environment. We set a model of households with 'real-world' mortgages in a partial equilibrium overlapping generations framework calibrated to UK data. We find that the welfare gains of the change of regime would have been considerable. However, the baseline calibration of the model implies that the volatility of aggregate consumption growth would actually be higher in the steady state in the more stable environment of the 1990s regime. This is due to greater synchrony in the response of households to shocks, offsetting the smaller magnitude of macroeconomic shocks. This effect is amplified by higher levels of debt in the 1990s. The result that aggregate consumption volatility could be higher in the current regime suggests that the observed fall in aggregate consumption volatility cannot necessarily be attributed to the more stable macroeconomic environment and the role of mortgage debt. If this result applies, this would suggest that the observed fall in volatility may be due either to other factors or may be a transitional phenomenon rather than a feature of the new steady state.

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Bibliographic Info

Paper provided by Bank of England in its series Bank of England working papers with number 273.

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Date of creation: Sep 2005
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Handle: RePEc:boe:boeewp:273

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  1. Christopher D. Carroll, 2001. "A Theory of the Consumption Function, With and Without Liquidity Constraints (Expanded Version)," NBER Working Papers 8387, National Bureau of Economic Research, Inc.
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Cited by:
  1. Waldron, Matt & Zampolli, Fabrizio, 2010. "Household debt, house prices and consumption in the United Kingdom: a quantitative theoretical analysis," Bank of England working papers 379, Bank of England.
  2. Andrew Benito, 2007. "Housing equity as a buffer: evidence from UK households," Bank of England working papers 324, Bank of England.

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