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Failure to Launch: Housing, Debt Overhang, and the Inflation Option During the Great Recession

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Can inflating away nominal mortgage liabilities cure debt overhang and combat a severe housing bust? With a focus on the Great Recession, I address this question using a structural macroeconomic model of illiquid housing, endogenous credit supply, and equilibrium default. First, I show that the model successfully replicates and provides insight into the dynamics of the U.S. economy since 2006. Second, I show that temporarily raising the inflation target would have cut foreclosures by over 60% and led to a more robust recovery in real economic variables. Price-level targeting that promises to offset this temporary inflation with future disinflation has more modest positive effects. In short, forward guidance matters. Higher inflation loses its potency in the counterfactual where all homeowners have adjustable rate mortgages, which highlights the importance of nominal rigidities for the e?ectiveness of these policies. Lastly, inflation proves effective even if wages exhibit substantial nominal stickiness.

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File URL: https://economics.missouri.edu/working-papers/2015/wp1515_hedlund.pdf
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Paper provided by Department of Economics, University of Missouri in its series Working Papers with number 1515.

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Length: 59 pages
Date of creation: 16 Oct 2015
Handle: RePEc:umc:wpaper:1515
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Web page: http://economics.missouri.edu/

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  6. Kearl, J R, 1979. "Inflation, Mortgages, and Housing," Journal of Political Economy, University of Chicago Press, vol. 87(5), pages 1115-1138, October.
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  8. Neil Bhutta & Jane K. Dokko & Hui Shan, 2010. "The depth of negative equity and mortgage default decisions," Finance and Economics Discussion Series 2010-35, Board of Governors of the Federal Reserve System (U.S.).
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  13. Aaron Hedlund, 2014. "Illiquidity and its Discontents: Trading Delays and Foreclosures in the Housing Market," Working Papers 1417, Department of Economics, University of Missouri.
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  15. Rios-Rull, Jose-Victor & Kuhn, Moritz, 2016. "2013 Update on the U.S. Earnings, Income, and Wealth Distributional Facts: A View from Macroeconomics," Quarterly Review, Federal Reserve Bank of Minneapolis, issue April, pages 1-75.
  16. Adrien Auclert, 2015. "Monetary Policy and the Redistribution Channel," 2015 Meeting Papers 381, Society for Economic Dynamics.
  17. Morris A. Davis & Andreas Lehnert & Robert F. Martin, 2008. "The Rent-Price Ratio For The Aggregate Stock Of Owner-Occupied Housing," Review of Income and Wealth, International Association for Research in Income and Wealth, vol. 54(2), pages 279-284, June.
  18. Jones, Lawrence D, 1993. "Deficiency Judgments and the Exercise of the Default Option in Home Mortgage Loans," Journal of Law and Economics, University of Chicago Press, vol. 36(1), pages 115-138, April.
  19. Rodney Ramcharan & Amir Kermani & Marco Di Maggio, 2015. "Monetary Policy Pass-Through: Household Consumption and Voluntary Deleveraging," 2015 Meeting Papers 256, Society for Economic Dynamics.
  20. Aladangady, Aditya, 2014. "Homeowner Balance Sheets and Monetary Policy," Finance and Economics Discussion Series 2014-98, Board of Governors of the Federal Reserve System (U.S.).
  21. Lars E.O. Svensson, 2003. "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others," Journal of Economic Perspectives, American Economic Association, vol. 17(4), pages 145-166, Fall.
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  24. Dean Corbae & Erwan Quintin, 2015. "Leverage and the Foreclosure Crisis," Journal of Political Economy, University of Chicago Press, vol. 123(1), pages 1-65.
  25. Jeske, Karsten & Krueger, Dirk & Mitman, Kurt, 2013. "Housing, mortgage bailout guarantees and the macro economy," Journal of Monetary Economics, Elsevier, vol. 60(8), pages 917-935.
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