Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/210007
Authors: 
Gelain, Paolo
Lansing, Kevin J.
Mendicino, Caterina
Year of Publication: 
2012
Series/Report no.: 
Working Paper 2012/08
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.
Subjects: 
asset pricing
excess volatility
credit cycles
housing bubbles
monetary policy
macroprudential policy
JEL: 
E32
E44
G12
O40
Persistent Identifier of the first edition: 
ISBN: 
978-82-7553-682-0
Creative Commons License: 
https://creativecommons.org/licenses/by-nc-nd/4.0/deed.no
Document Type: 
Working Paper
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