Executive Summary While the economy shows signs of strength, the recovery remains tepid relative to economic upswings following deep recessions of the past. This weakness has occurred despite an aggressive monetary response by the Federal Reserve which has adopted even unconventional tools to reduce long term interest rates. A variety of factors have been blamed for the tepid recovery, including the financial crisis of 2008, uncertainty over policy, and high levels of indebtedness. In this report, we focus on weakness in housing. Our analysis makes two broad points. First, weakness in housing and residential investment is a main impediment to a robust recovery. Second, problems related to housing have affected the transmission of monetary policy. More specifically, the unprecedented decline in house prices and residential investment has introduced headwinds that may require a more aggressive monetary response than in normal downturns. Further, problems related to housing markets may reduce the sensitivity of real economic activity to the interest rates that monetary policy can affect. Or in the parlance of textbook intermediate macroeconomics, housing problems have likely shifted the IS curve leftwards and steepened the slope of the curve by introducing a gap between policy rates and effective rates. For both of these reasons, problems related to housing introduce significant challenges to monetary policy-making. There are six steps in our analysis: 1. We begin by placing housing in the context of the broader economic recovery. The overall recovery in GDP has been one of the weakest in the postwar period even though the recession was the largest in the postwar period. Residential investment has been a particularly dismal performer. Further, the other weakest components of GDP--consumption of services and state and local government expenditures--can also be closely linked to weakness in housing markets. Focusing just on the direct impact of housing-home construction and housing service consumption-the sector accounts for about a third of the shortfall of growth relative to a typical recovery. Obviously the full impact of the housing crisis is bigger if we include indirect impacts on local governments and consumption of housing-related durables. We also show evidence from other countries that a collapse in housing is associated with subsequently weak recoveries. 2. We then take a closer look at housing in particular. Weakness in housing construction is driven by continued weakness in the construction and sales of single-family homes. There is some evidence of a silver lining in construction of multi-family buildings and existing home renovation activity. However, there remain severe problems related to the physical overhang of existing vacant properties, foreclosures, tightened credit conditions, and weakness in household balance sheets. While there is some recent optimism related to residential investment numbers in the last quarter, residential investment levels remain very low and house prices continued to decline even into the end of 2011. 3. What is the role of monetary policy in addressing weakness in housing? Monetary policy would normally lower the user cost of housing by increasing consumer and house price expectations and lowering mortgage rates. This would induce more demand for housing, alleviate collateral constraints on household borrowing, and increase the flow of income to homeowners through refinancing into lower interest rates. 4. But the collapse in housing markets may hinder the ability of monetary policy to operate through these channels. In particular, the physical overhang of existing properties introduces a serious headwind that may require very large and unrealistic reductions in the user cost of housing to generate a recovery in residential investment. Foreclosures and depressed house price expectations only add to this problem. Further, the collapse in house prices and tight credit conditions may limit the ability of borrowers to access low interest rates. Or in other words, problems related to housing introduce a large wedge between rates that the Federal Reserve can affect and the rates at which households can realistically borrow. 3 5. To quantify the effect of physical overhang, we present a simple model of the desired versus actual housing stock and estimate the model using aggregate data. Desired housing is a function of non-housing consumption and the user cost of housing. The estimation of the model reveals the severity of the physical overhang problem: the housing stock as of 2010q4 remains about 9% above its desired level. In the baseline estimation, mortgage interest rates would need to be negative to bring down the user cost to a level that would equate desired housing with actual housing. The analysis suggests physical overhang presents a significant headwind to monetary policy--even if long term mortgage rates were reduced substantially from their already historical lows, the desired housing stock would likely still be lower than the existing housing stock. Our analysis paints a pessimistic picture for residential investment going forward even if mortgage rates decline further. 6. We also quantify the magnitude of housing-related problems by using cross-sectional data across states. There is a significant amount of such variation: states such as Arizona, California, Florida, and Nevada experienced severe declines in house prices whereas states such as the Dakotas, Iowa, and Texas largely avoided the housing bust. Problems related to housing are much more severe in large house price decline states: vacancy rates are significantly higher, households are unable to refinance into lower rates, and delinquencies and foreclosures are at extremely high levels. These housing-related problems appear to be impacting the real economy: new residential investment, renovations, and spending on durable goods are all significantly lower in these areas, even through the end of 2011. We can use our cross-sectional estimates to quantify the degree to which housing problems have weakened the transmission of monetary policy by assuming monetary policy is fully effective in states without severe housing problems. Relative to the observed mean values for all states, renovations, new residential investment, and auto sales purchases are 19, 5, and 10 percentage points higher relative to their 2006 levels in states in which monetary policy is fully effective. This suggests impediments to monetary policy transmission in states with large house price declines are important to understanding weakness in residential investment and durable consumption during the recovery. We conclude by discussing what our results imply for policy. Both the aggregate and cross-sectional analysis suggests that weakness in housing presents challenges to the transmission of monetary policy to the real economy. The sensitivity of real economic activity to changes in rates that the Federal Reserve can affect may be substantially lower given the housing situation. In light of these challenges, we are in support of programs that directly tackle issues in housing, such as programs that facilitate refinancing for underwater mortgages and help transition foreclosure inventory into rentals. In this sense, we are in agreement with recent policy advice emerging from members of the Federal Reserve (e.g., Federal Reserve Board Staff (2012) and Dudley 4

Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in Abstract The housing boom that preceded the Great Recession was the result of an increase in credit supply driven by looser lending constraints in the mortgage market. This view on the fundamental drivers of the boom is consistent with four empirical observations: the unprecedented rise in home prices, the surge in household debt, the stability of debt relative to home values, and the fall in mortgage rates. These facts are difficult to reconcile with the popular view that attributes the housing boom to looser borrowing constraints associated with lower collateral requirements. In fact, a slackening of collateral constraints at the peak of the lending cycle triggers a fall in home prices in our framework, providing a novel perspective on the possible origins of the bust.

Abstract. The housing boom that preceded the Great Recession was due to an increase in credit supply driven by looser lending constraints in the mortgage market. This view on the fundamental drivers of the boom is consistent with four empirical observations: the unprecedented rise in home prices and household debt, the stability of debt relative to house values, and the fall in mortgage rates. These facts are difficult to reconcile with the popular view that attributes the housing boom to looser borrowing constraints associated with lower collateral requirements. In fact, a slackening of collateral constraints at the peak of the lending cycle triggers a fall in home prices in our framework, providing a novel perspective on the possible origins of the bust.

Abstract We recast the Aiyagari-Bewley-Huggett model of income and wealth distribution in continuous time. This workhorse model -as well as heterogeneous agent models more generally -then boils down to a system of partial differential equations, a fact we take advantage of to make two types of contributions. First, a number of new theoretical results: (i) an analytic characterization of the consumption and saving behavior of the poor, particularly their marginal propensities to consume; (ii) a closed-form solution for the wealth distribution in a special case with two income types; (iii) a proof that there is a unique stationary equilibrium if the intertemporal elasticity of substitution is weakly greater than one; (iv) a characterization of "soft" borrowing constraints. Second, we develop a simple, efficient and portable algorithm for numerically solving for equilibria in a wide class of heterogeneous agent models, including -but not limited to -the Aiyagari-Bewley-Huggett model. * This version supersedes an earlier version of the paper entitled "Heterogeneous Agent Models in Continuous Time." We are grateful to Fernando Alvarez, Adrien Auclert, Dave Backus, Roland Bénabou, Jess Benhabib, Jocelyn Boussard, Paco Buera, Lorenzo Caliendo, Dan Cao, Wouter Den Haan, Xavier Gabaix, Mark Huggett, Mariacristina De Nardi, Greg Kaplan, Nobu Kiyotaki, Ellen McGrattan, Giuseppe Moscarini, Galo Nuño, Ezra Oberfield, Alan Olivi, Jesse Perla, Matt Rognlie, Tony Smith, Ivan Werning, Wei Xiong, Stan Zin and seminar participants at various institutions for useful comments. We also thank Déborah Sanchez for stimulating discussions in early stages of this project and SeHyoun Ahn, Riccardo Cioffi, Xiaochen Feng and Max Vogler for outstanding research assistance.

Abstract. We use a quantitative equilibrium model with houses, collateralized debt and foreign borrowing to study the impact of global imbalances on the U.S. economy in the 2000s. Our results suggest that the dynamics of foreign capital flows account for between one fourth and one third of the increase in U.S. house prices and household debt that preceded the financial crisis. The key to these findings is that the model generates the sustained low level of interest rates observed over that period.

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This paper presents preliminary findings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments. The views expressed in the paper are those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors. Investment Shocks and Business Cycles

This paper shows how the empirical implications of incomplete markets models can be assessed using the same full-information methods that are commonly used for representative agent models. It then asks what features of the microeconomic insurance arrangement are important for understanding the dynamics of aggregate consumption as it relates to aggregate labor income and employment conditions. A model with a low level of insurance against unemployment risk and an intermediate level of insurance against individual skill shocks provides the best fit of the aggregate data. A model that matches the strong consumption responses to fiscal stimulus payments does not improve the overall fit to the aggregate data.

In this paper, we construct a life cycle model with housing demand and incomplete market to explore the relationship between housing demand, accompanied with underdeveloped housing finance, and the household saving rate in China. We investigate two types of finance imperfection: a) the high down payment ratio required by central bank, and b) the unsmooth home equity withdrawal due to the prohibitive nature of refinancing. Without access to home equity withdrawal, households have to hold a considerable amount of non-housing asset such as deposit, cash, and bond as it is difficult for them to insure against negative income shocks and retirement via housing asset. This helps to account for the rising household saving rate during the past 10 years in China where commercialized housing market had been emerging. Yet interestingly on another note, we find higher down payment ratio leads to a substitution between housing and non-housing assets, leaving the aggregate household saving rate almost unchanged.

This paper compares partial and general equilibrium effects of alternative financial aid policies intended to promote college participation. We build an overlapping generations life-cycle, heterogeneous-agent, incomplete-markets model with education, labor supply, and consumption/saving decisions. Altruistic parents make inter vivos transfers to their children. Labor supply during college, government grants and loans, as well as private loans, complement parental transfers as sources of funding for college education. We find that the current financial aid system in the U.S. improves welfare, and removing it would reduce GDP by two percentage points in the long-run. Any further relaxation of government-sponsored loan limits would have no salient effects. The short-run partial equilibrium effects of expanding tuition grants (especially their need-based component) are sizeable. However, long-run general equilibrium effects are 3-4 times smaller. Every additional dollar of government grants crowds out 20-30 cents of parental transfers. JEL Classification: E24, I22, J23, J24.