TAILIEUCHUNG - House Prices, Credit Growth, and Excess Volatility: Implications for Monetary and Macroprudential Policy

A major difference between this concept and Kornai’s notion of soft budget constraints lies in the ex-ante attitude of creditors. While creditors (in particular, the state) explicitly bail out unprofitable firms (this information is available ex-ante), the adverse selection in the second case is due to imperfect information: if the relevant information had been available to the creditors ex-ante, they would have declined to finance the project altogether (Schaffer (1998)). In reference to long-term enterprise-bank relations in a transitional environment, it has been observed that relationship banking in imperfect markets may also involve moral hazard and may give rise. | FEDERAL RESERVE BANK OF SAN FRANCISCO WORKING PAPER SERIES House Prices Credit Growth and Excess Volatility Implications for Monetary and Macroprudential Policy Paolo Gelain Norges Bank Kevin J. Lansing Federal Reserve Bank of San Francisco and Norges Bank Caterina Mendicino Bank of Portugal August 2012 Working Paper 2012-11 http publications economics papers 2012 The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System. House Prices Credit Growth and Excess Volatility Implications for Monetary and Macroprudential Policy Paolo Gelaiii Kevin J. Lansing Caterina Mendicino Norges Bank FRB San Francisco and Norges Bank Bank of Portugal August 10 2012 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 .

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