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Housing and Monetary Policy in the Business Cycle: What do Housing Rents have to Say?

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  • Joao Bernardo Duarte
  • Daniel A. Dias

Abstract

In this paper we unveil a feedback loop between monetary policy, housing tenure choice (own vs rent) and measured inflation and quantify its consequences. This feedback loop is explained in three parts: i) Housing rents respond positively to contractionary monetary policy shocks; ii) This effect of interest rates on housing rents gives rise to an important and systematic inflation mismeasurement problem because, directly and indirectly, housing rents weigh approximately 30\% in the CPI and 13\% in the PCE; iii) When interest rates are set according to a Taylor rule, the systematic mismeasurement of inflation gives rise to a feedback loop by which the monetary authority keeps setting interest rates too high (low) because inflation is apparently too high (low). To rationalize i) and quantify the importance of iii) we propose a standard New Keynesian model augmented with an endogenous housing tenure choice mechanism. Using a calibrated version of the model, we do a counterfactual exercise and estimate that, when the monetary authority targets the implied consumer price index net of housing rents instead of the implied consumer price index, the loss function of monetary policy is 14.5\% lower and the welfare in terms of consumption equivalent variation is 0.9\% higher. Finally, analyzing the same alternative scenario for the 1983-2006 US experience, we find that the standard deviation of housing prices and nominal inflation would have been 24.8\% and 19.9\% lower, respectively.

Suggested Citation

  • Joao Bernardo Duarte & Daniel A. Dias, 2015. "Housing and Monetary Policy in the Business Cycle: What do Housing Rents have to Say?," 2015 Papers pdu385, Job Market Papers.
  • Handle: RePEc:jmp:jm2015:pdu385
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    References listed on IDEAS

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    1. Uhlig, Harald, 2005. "What are the effects of monetary policy on output? Results from an agnostic identification procedure," Journal of Monetary Economics, Elsevier, vol. 52(2), pages 381-419, March.
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    Cited by:

    1. Giancarlo Corsetti & Joao B. Duarte & Samuel Mann, 2018. "One Money, Many Markets," Discussion Papers 1805, Centre for Macroeconomics (CFM).
    2. Corsetti, G. & Duarte, J. B. & Mann, S., 2018. "One Money, Many Markets - A Factor Model Approach to Monetary Policy in the Euro Area with High-Frequency Identification," Cambridge Working Papers in Economics 1816, Faculty of Economics, University of Cambridge.
    3. Gazzani, Andrea, 2016. "News and noise in the housing market," Working Paper Series 1933, European Central Bank.
    4. Vorada Limjaroenrat, 2017. "Distributional Effects of Monetary Policy on Housing Bubbles: Some Evidence," PIER Discussion Papers 74, Puey Ungphakorn Institute for Economic Research.

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    More about this item

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • R21 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Household Analysis - - - Housing Demand

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