Abstract
The collapse of housing prices in the U.S. during the Great Recession eroded not only consumers’ housing wealth but also the assets held by the banking sector. I introduce a micro-founded banking sector to a standard DSGE model with household debt to study the interaction between housing prices, household debt, and banks’ balance sheet positions. I estimate the model using US data from 1991Q1 to 2014Q1 and find that there is a significant spillover effect from the housing market to the rest of the aggregate economy. The spillover effect is mainly evident on investment through the banking sector. A negative shock to housing demand or to the perceived riskiness of assets backed by housing wealth decreases the banks’ net worth. As a result, both mortgage and corporate spreads rise, leading to a decline in aggregate investment. I also find that an unconventional monetary policy is more effective in dampening the downturn when it targets the assets backed by housing wealth.
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