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Housing collateral and the monetary transmission mechanism

by Karl Walentin and Peter Sellin

Sveriges Riksbank

APRIL 2010


In this paper our main aim is to quantify the role that housing collateral plays for the monetary transmission mechanism. Furthermore, we want to explore the implications of the increase in household indebtedness, and specifically the loan-to-value ratio, in the last two decades. We set up a two sector DSGE model with production of goods and housing. Households can only borrow by using their houses as collateral. The structure of the model closely follows Iacoviello and Neri (2010). To be able to do quantitatively relevant exercises we estimate the model using Bayesian methods on Swedish data for 1986q1-2008q3. We quantify the reinforcement of the monetary transmission mechanism that housing used as collateral implies in the presence of nominal loan contracts. This mechanism functions through the effects of the interest rate on house prices as well as on inflation and thereby the real value of nominal debt. This component of the monetary transmission mechanism becomes stronger the higher the loan-to-value ratio is. A change in the maximum loan-to-value ratio from 85% to 95%, all else being equal, implies that the effect of a monetary policy shock is increased by 4% for inflation, 8% for GDP and 24% for consumption. We conclude that to properly understand the monetary transmission mechanism and its changing nature over time, we need to take into account the effects of housing related collateral constraints.

This is very "now" research, we should see the implications of this kind of work in the UK Budget speech on Tuesday and I think its fair to say that the recent joint article in the FT by David Cameron and Frederik Reinfeldt reflects a working closeness between Sweden and the UK which you may not see between the Chairman and CEO of BP!!! The article is here

Also a recent speech by the Deputy Governor of the Sveriges Riksbank reflects I think this kind of analysis and thinking in terms of the policy challenges of LTV. Its not as simple as LTV of course but its close. That speech is below;-

as a PS, when I was first ask to look at what was then called "this Basel Malarky" back in '03 initially of all the work that made most sense back then, the best was the research from the Sveriges Riksbank, no question (possibly for obvious reasons, I suppose) but I remember the papers of the SR from that period as being the best, I suppose this is a note to self, I should blog some of those early papers here.

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