Expectation-driven house prices and debt defaults: The effectiveness of monetary and macroprudential policies

Abstract

We embed non-fundamental house price expectation shocks and endogenous mortgage defaults into a DSGE model with a housing and banking sector. We use our DSGE set-up to study the impact of variations in house price expectations upon macroeconomic dynamics and their implications for monetary and macroprudential policies. Model simulations show that an increase in expected future house prices leads to a decline in mortgage defaults and interest rates on loans, whereas it leads to an increase in house prices, household debt, bank leverage ratios and economic activity. Interestingly, a positive fundamental housing preference shock causes a rise in inflation, whilst a positive non-fundamental shock to house prices generates a decline in inflation. We demonstrate that even though monetary policy reacting to household credit growth improves the stability of the real economy, yet it jeopardizes price stability. Finally, we show that the effectiveness of monetary versus macroprudential policy depends on whether the economy is affected by non-fundamental or fundamental shocks.