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House Prices, Credit Growth, and Excess Volatility: Implications for Monetary and Macroprudential Policy

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  • Gelain, Paolo
  • Lansing, Kevin J.
  • Mendicino, Caterina

Abstract

Progress on the question of whether policymakers should respond directly to financial variables requires a realistic economic model that captures the links between asset prices, credit expansion, and real economic activity. Standard DSGE models with fully-rational expectations have difficulty producing large swings in house prices and household debt that resemble the patterns observed in many developed countries over the past decade. We introduce excess volatility into an otherwise standard DSGE model by allowing a fraction of households to depart from fully-rational expectations. Specifically, we show that the introduction of simple moving-average forecast rules for a subset of households can significantly magnify the volatility and persistence of house prices and household debt relative to otherwise similar model with fully-rational expectations. We evaluate various policy actions that might be used to dampen the resulting excess volatility, including a direct response to house price growth or credit growth in the central bank’s interest rate rule, the imposition of more restrictive loan-to-value ratios, and the use of a modified collateral constraint that takes into account the borrower’s loan-to-income ratio. Of these, we find that a loan-to-income constraint is the most effective tool for dampening overall excess volatility in the model economy. We find that while an interest-rate response to house price growth or credit growth can stabilize some economic variables, it can significantly magnify the volatility of others, particularly inflation.

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Bibliographic Info

Paper provided by CEPREMAP in its series Dynare Working Papers with number 21.

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Length: 45 pages
Date of creation: Dec 2012
Date of revision:
Handle: RePEc:cpm:dynare:021

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Keywords: asset pricing; excess volatility; credit cycles; housing bubbles; monetary policy; macroprudential policy;

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  1. House Prices, Credit Growth, and Excess Volatility: Implications for Monetary and Macroprudential Policy
    by Christian Zimmermann in NEP-DGE blog on 2013-01-14 04:51:55
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Cited by:
  1. Leonardo Gambacorta & Federico M. Signoretti, 2013. "Should monetary policy lean against the wind? An analysis based on a DSGE model with banking," Temi di discussione (Economic working papers) 921, Bank of Italy, Economic Research and International Relations Area.
  2. Crowe, Christopher & Dell’Ariccia, Giovanni & Igan, Deniz & Rabanal, Pau, 2013. "How to deal with real estate booms: Lessons from country experiences," Journal of Financial Stability, Elsevier, vol. 9(3), pages 300-319.
  3. Pierre-Richard Agénor & Luiz A. Pereira da Silva, 2013. "Inflation Targeting and Financial Stability: A Perspective from the Developing World," Working Papers Series 324, Central Bank of Brazil, Research Department.
  4. Tony Hall & Jan Jacobs & Adrian Pagan, . "Macro-Econometric System Modelling @75," NCER Working Paper Series 95, National Centre for Econometric Research.
  5. Pierre-Richard Agénor & Luiz A. Pereira da Silva, 2011. "Macroprudential Regulation and the Monetary Transmission Mechanism," Working Papers Series 254, Central Bank of Brazil, Research Department.
  6. Canuto, Otaviano & Cavallari, Matheus, 2013. "Monetary policy and macroprudential regulation : whither emerging markets," Policy Research Working Paper Series 6310, The World Bank.
  7. Pei Kuang, 2013. "Imperfect Knowledge About Asset Prices and Credit Cycles," Discussion Papers 13-02r, Department of Economics, University of Birmingham.
  8. Paolo Gelain & Kevin J. Lansing, 2013. "House prices, expectations, and time-varying fundamentals," Working Paper 2013/05, Norges Bank.

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