The role of housing wealth on economic activity has recently attracted considerable attention among academic researchers, policy makers and press commentators. This attention is partly explained by the sizeable rises in property prices and household indebtedness in several industrialized countries over the recent years (Debelle 2004, Terrones and Otrok 2004), and the need to understand both the determinants of such rises and their potential implications for monetary policy and financial stability. The recent global financial turmoil allegedly originating from the residential property market in the US has strengthened the interest in these matters even further. Beyond the policy considerations, there is a growing interest in assessing the effects of changes in property prices on consumption decisions, given the predominance of housing in total household wealth (Campbell and Cocco 2003, Muellbauer and Murphy 2008).
This paper studies the relationship between the structure of housing finance and the monetary transmission mechanism in several industrialized countries. We first show that there is significant heterogeneity in the institutional characteristics of national mortgage markets across the main industrialized countries, and especially within the EU. Examples of such institutional characteristics include the typical duration of mortgage contracts, the required levels of down%payment (or inverse loan%to%value ratios), the existence (or lack thereof) of equity release products. We interpret these indicators as alternative measures of the degree of development/flexibility of mortgage markets. There is in fact one channel, working from housing finance to the macroeconomy, that we aim at capturing by means of these indicators: the extent to which mortgage contracts allow to translate the value of housing as a collateral into current availability of credit for households. In turn, this credit can be used not only to finance new housing expenditure but also (non housing) consumption.
In addition to the aforementioned indicators we also classify countries according to the prevailing interest rate structure of mortgage contracts, namely flexible vs. fixed interest rate contracts. We treat this indicator separately for it does not necessarily reflect a higher or lower degree of development of mortgage markets. We believe this channel may be particularly important for the transmission of monetary policy, especially on consumption, for it represents a direct channel through which monetary policy, by altering the service cost of debt, can affect current disposable income.
We then conduct a VAR based analysis of the effects of monetary policy shocks on consumption, house prices and residential investment in a sample of industrialised countries. We classify the countries into two groups, according to their degree of development of mortgage markets. Those belonging to the first (second) group are countries where LTV ratios are low, mortgage equity release is common (absent or partial) and the ratio of mortgage debt to GDP is high (low). We then also classify countries according to their prevailing interest rate structure of mortgage contracts (fixed vs. variable rate).
We find two main results. First, the size of the peak effect of a monetary policy shock on residential investment is positively and significantly related both to our indicators of flexibility in mortgage markets (with higher flexibility translating into larger sensitivity) and to the type of interest rate structure (with residential investment being significantly more responsive to policy innovations in those countries with a variable rate mortgage structure). A similar pattern emerges for the response of house prices. Second, we find that the evidence for consumption is mixed. Namely, consumption is significantly more responsive only in those countries where mortgage equity release is common and, especially, where prevailing mortgage contracts are of the variable rate type. Other indicators of mortgage markets flexibility, such as the LTV ratio or the ratio of mortgage debt to GDP, turn out not to be relevant for the differential response of consumption across countries to monetary innovations.
Under frictionless financial markets, the structure of housing finance should in principle be immaterial for the effects of monetary shocks. To rationalize our evidence we build a model that extends the baseline monetary policy framework in three main directions. First, it allows for two sectors, respectively producing consumption goods and new housing. Second, it features heterogeneity of preferences between impatient consumers and patient consumers (in equilibrium, borrowers and savers respectively). The former do not act as standard permanent income agents, but exhibit preferences tilted towards current consumption. The borrowers may be thought of as that share of the population for which acquiring a loan/mortgage requires providing an asset, and housing in particular, as a form of collateral. Third, private borrowing is constrained by the value of the collateral. That value is endogenously tied to the evolution of the price of housing.
Thus, in a context where mortgage markets allow more easily to convert asset values into borrowing, and therefore spending, consumption and residential investment should be more responsive to underlying shocks. In our framework, the relevant institutional features of the mortgage market are summarized by two main parameters: the down payment rate, and the interest rate structure of the contract. We calibrate and simulate the model based on our introductory evidence on the heterogenous characteristics of mortgage markets in industrialized countries. We find that both institutional features magnify the responses of consumption and residential investment to monetary policy shocks.
General equilibrium borrower saver models build on the earlier analysis of Kiyotaki and Moore (KM) (1997) and Krusell and Smith (1998). Recently, Iacoviello (2005) extends the KM framework to include features more typical of the New Keynesian monetary policy literature, whereas Campbell and Hercowitz (2004) extend this category of models to a real business cycle framework and explore the role of credit market innovations in contributing to the so%called Great Moderation. The modelling section of our work is related to the last two papers, but it differs in two main ingredients: first, it features a two sector structure (so that residential investment is an endogenous variable); second, it models institutional characteristics of the mortgage market (such as variable vs. fixed rate contracts) and analyzes how they shape the transmission of monetary policy shocks.
The paper is structured as follows. In Section 2 we document some key institutional differences in mortgage markets across industrialized countries. We conduct some VAR based empirical analysis in Section 3, focussing on the impact of a monetary policy shock on housing market related variables. The structural model is developed in Section 4 and discussed in Section 5. Section 6 presents some dynamic simulations. Section 7 concludes.
Content
Abstract
Non-technical summary
1 Introduction
2 Housing finance in the industrialized countries 10
3 Housing finance and monetary policy
transmission: the evidence
4 The model
- 4.1 Final good producers
4.2 Borrowers
4.3 Savers
4.4 Production and pricing of intermediate goods
4.5 Market clearing
4.6 Monetary policy
5 The channels of monetary policy transmission
6 Dynamic simulations
- 6.1 Calibration
6.2 The role of the collateral constraint
7 Conclusions
References
Tables and figures
European Central Bank Working Paper Series
