House Prices, Heterogeneous Banks and Unconventional Monetary Policy Options

This paper develops a financial mechanism which integrates housing and the real economy through housing-secured debt. In this environment, movements in home prices are amplified through both borrowers and banks’ balance sheets, leading to a self-reinforcing credit/liquidity crunch. When placed within a traditional business cycle model, this financial structure quantitatively captures empirical relationships the traditional financial accelerator mechanism struggles to explain and the qualitative predictions of the model are consistent with dynamic responses from a VAR. The model provides a framework to examine the ability of QE policies and equity injections into big banks to mitigate a housing bust. Although both are effective, the nuances of the policies are important. A prolonged asset purchase program is preferable to a short-term equity injection; however, the model suggests the equity injections may have been necessary to prevent an economic collapse at the acute stage of the 2008 Financial Crisis.