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Monetary Neutrality, Home Mortgages, and the Phillips Curve

Alan Day Haight
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Alan Day Haight: State University of New York, Cortland

A chapter in Proceedings of the International Conference on Human and Economic Resources, 2006, pp 360-365 from Izmir University of Economics

Abstract: Standard mortgage borrowing practices are incorporated into a model of the loanable funds market. Contrary to the Taylor rule (which is for short-term rates), in this model an increase in inflation causes the long-term nominal rate to rise by a smaller amount, leaving the real rate lower. In turn, the lower long-term real interest rate stimulates investment, growth, and employment. As in the recent literature on the New Keynesian Phillips Curve, the long-run Phillips curve produced by this model is not vertical, and money is not neutral. Higher inflation reduces unemployment in the long run, even when inflationary expectations are fulfilled. The cause of this violation of the classical dichotomy is bounded rationality: to simplify a complex decision regarding how much to borrow, home buyers erroneously focus on their payment-to-income ratio, which is a function of the nominal interest rate, not the real interest rate. Central-Bank success at fighting inflation diverts loanable funds for productive investment into housing and other consumer durables.

Keywords: mortgage; loanable funds; bounded rationality; Phillips Curve; Monetary Neutrality (search for similar items in EconPapers)
Date: 2006
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