Failure to Launch: Housing, Debt Overhang, and the Inflation Option

Aaron Hedlund

doi:10.1257/mac.20160371

Abstract

Can inflating away nominal mortgage liabilities effectively combat recessions? I address this question using a model of illiquid housing, endogenous credit supply, and equilibrium default. I show that, in an ordinary recession, temporarily raising the inflation target has only modest or even counterproductive effects. However, during episodes like the Great Recession, inflation effectively boosts house prices, consumption, and dramatically cuts foreclosures, but only when fixed-rate mortgages are the dominant instrument. The quantitative implications of inflation also vary if other nominal rigidities or demand externalities are present. In the cross section, inflation delivers especially large gains to highly leveraged homeowners. (JEL D14, E31, E32, E52, G21, R31)

Highlights

In response to the unprecedented collapse in the housing market and macroeconomy during the Great Recession, the U.S government undertook dramatic interventions to pull the economy out of its slump
The interaction of endogenous credit constraints and housing illiquidity in this paper proves crucial to the efficacy of inflationary policies
Debt, deleveraging, and default remain issues of interest as the economy moves beyond the Great Recession

Summary

Introduction

In response to the unprecedented collapse in the housing market and macroeconomy during the Great Recession, the U.S government undertook dramatic interventions to pull the economy out of its slump. Inflation in this scenario boosts house prices (both nominal and real) and reduces foreclosures, but the contraction in mortgage supply causes consumption to initially fall before recovering.

Results

Conclusion