Hou prices, consumption, and monetary policy: a financial accelerator
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James Proudman**
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Working Paper no. 169
*kosuke.uk, Monetary Asssment and Strategy Division, Bank of England, and CEPR.
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=jan.uk, Monetary Asssment and Strategy Division, Bank of England, an
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pipetteWe would like to thank Mark Gertler and Simon Gilchrist for invaluable suggestions and advice. We would also like to thank Peter Andrews, Larry Ball, Charles Bean, Chris Carroll, Roy Cromb, Spencer Dale, Emilio Fernandez-Corugedo, Jan Groen, Andrew Haur, Anil Kashyap, Frederic Mishkin, Ed Nelson and John Vickers, and conference participants at the Federal Rerve Bank of New York, the Bank of Japan, and the Bank of England for helpful comments. The views expresd here are tho of the authors and do not necessarily reflect tho of the Bank of England. An earlier version of this paper was entitled ‘Hous as collateral: has the link between hou prices and consumption in the UK changed?’ and a non-technical version of it was published under the same title in the Federal Rerve Bank of New York Economic Policy Review.
Copies of working papers may be obtained from Publications Group, Bank of England, Threadneedle Street, London, EC2R 8AH; telephone 020 7601 4030, fax 020 7601 3298,
e-mail ukdeltoro
Working papers are also available at uk/wp/index.html
The Bank of England’s working paper ries is externally refereed.
© Bank of England 2002
ISSN 1368-5562
Abstract5 Summary7 1Introduction9 2A brief description of the UK housing market11 3The effect of monetary policy on hou prices:some V AR results14 4Modelling the houhold credit channel15 5The model20 6Model simulations26 7Conclusion31 Appendix1:Complete log-linearid model33 Appendix2:Parameterisation36 Appendix3:Data sources38 References39
There is a live debate about the role of hou prices in the transmission mechanism of monetary policy.Do hou prices merely reflect macroeconomic conditions,or are there important feedback effects from hou prices to other economic variables?We consider a general equilibrium model where asymmetric information problems create frictions in credit markets ud by houholds.In particular,we apply thefinancial accelerator mechanism of Bernanke,Gertler and Gilchrist to the houhold ctor.In our economy,hous rve two purpos:they provide a stream of housing rvices to consumers and they rve as collateral to lower the agency costs related to borrowing. We show that under certain conditions this amplifies and propagates the effect of monetary policy shocks on housing investment,hou prices and consumption.We also consider the effect of a struct
ural change in credit markets that lowers the transaction costs of additional borrowing against housing equity.We show that such a change would increa the effect of monetary policy shocks on consumption,but would decrea the effect of monetary policy shocks on hou prices and housing investment.
Key words:Hou prices,credit frictions,monetary policy,financial accelerator,consumption. JEL classification:E32,E50,R21.
The Bank has a long-standing interest in the role of hou prices in the transmission mechanism of monetary policy.Do hou prices merely reflect macroeconomic conditions,or are there important feedback effects from hou prices to other economic variables?There have been structural changes in the retailfinancial markets in the United Kingdom since the late1980s.Following deregulation in the mortgage market,it has become easier and cheaper for consumers to borrow against housing collateral tofinance consumption.What implications do the structural changes have for monetary policy?
In this paper,we model houholds’consumption and housing decisions taking account of the possible importance of credit frictions.Our hypothesis is that hou prices play a role becau housin
g is ud as collateral to reduce the agency costs associated with borrowing tofinance housing investment and consumption.Our motivation is bad on three obrvations for the United Kingdom:(i)hou prices and housing investment are strongly cyclical,which leads to substantial variation in houholds’collateral position over the business cycle;(ii)the amount of cured borrowing tofinance consumption is cloly related to this collateral position;(iii)the spread of mortgage rates over the risk-free interest rate varies with the collateral position of each houhold.The stylid facts suggest credit frictions and houholds’u of their housing equity as collateral may be important in understanding the relationship between interest rates, hou prices,housing investment and consumption.
Our model applies afinancial accelerator mechanism to the houhold ctor.When hou prices fall,houholds that are moving home have a smaller deposit(ie net worth)available than they otherwi would for the purcha of their next home.When they have a smaller deposit,they obtain less favourable mortgage interest rates when renegotiating their mortgage,and have less scope for extracting additional equity tofinance consumption.Fluctuations in hou prices
significantly affect the value of hous as collateral and therefore strongly influence borrowing conditions for houholds.
We show,by simulation,that thefinancial accelerator mechanism described above amplifies and propagates the respons of the economy to various shocks.We also consider the implications of recent deregulation in the mortgage market.Our simulation shows that cheaper access to home
equity means that,for a given hou price ri,more additional borrowing will be devoted to consumption relative to housing investment.This has important implications for how hou price movements should be interpreted,becau it implies that the relationship between hou prices and consumption has changed over time.
