Credit frictions and consumption dynamics in an open economy

Abstract

This paper incorporates a collateral constraint and a banking sector into the New Keynesian dynamic stochastic general equilibrium (DSGE) model. With the presence of credit frictions and interest rate rigidity, we examine the dynamics between housing prices, housing consumption and interest rates in response to policy shocks and exchange rate shocks. Unanticipated monetary contraction and currency depreciation decrease collateral-constrained households' housing consumption in accordance with lower home prices, less availability of domestic borrowing and lower lending rates. Compared to a closed economy, policy shocks have larger spillover effects on housing consumption in an open economy since the availability of foreign borrowing magnifies the impact of declining housing prices.