Credit Cycles with Market Based Household Leverage

William Diamond and Tim Landvoigt
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William Diamond: Wharton School, University of Pennsylvan
Tim Landvoigt: University of Pennsylvania

No 162, 2019 Meeting Papers from Society for Economic Dynamics

Abstract: We develop a model in which mortgage leverage available to households depends on the risk bearing capacity of financial intermediaries. Our model features a novel transmission mechanism from Wall Street to Main Street, as borrower households choose lower leverage and consumption when intermediaries are distressed. The model has financially constrained young and unconstrained middle-aged households in overlapping generations. Young households choose higher leverage and riskier mortgages than the middle-aged, and their consumption is particularly sensitive to credit supply. Relative to a standard model with exogenous credit constraints, the macroeconomic importance of intermediary net worth is magnified through its effects on household leverage, house prices, and consumption demand. The model quantitatively demonstrates how recessions with housing crises differ from those driven only by productivity, and how a growing demand for safe assets replicates many features of the 2000s credit boom and increases the severity of future financial crises.

Date: 2019
New Economics Papers: this item is included in nep-dge and nep-ure
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