Mortgages and monetary policy

By Carlos Garriga, Finn Kydland and Roman Šustek

Mortgage loans are a striking example of a persistent nominal rigidity. As a result, under incomplete markets, monetary policy affects decisions through the cost of new mortgage borrowing and the value of payments on outstanding debt. Observed debt levels and payment to income ratios suggest the role of such loans in monetary transmission may be important. A general equilibrium model is developed to address this question. The transmission is found to be stronger under adjustable- than fixed-rate contracts. The source of impulse also matters: persistent inflation shocks have larger effects than cyclical fluctuations in inflation and nominal interest rates.

If monetary policy has an impact on inflation, it has real consequences on those with real liabilities. The literature focuses on nominal bonds and neglects mortgages, which this paper shows to be important. To my surprise, monetary policy has a stronger impact with adjustable mortgage rates compared to fixed ones. This comes from a combination of a price effect for new mortgages that redistributes the burden of the mortgage over its lifetime and a traditional wealth effect for ongoing mortgages where the inflation rate matters, as well as, for adjustable rate mortgages, the short-term interest rate. This is difficult to summarize in a few sentences, read the paper.

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