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Financial Frictions, Durable Goods and Monetary Policy

Ugochi Emenogu and Leo Michelis ()

Staff Working Papers from Bank of Canada

Abstract: Financial frictions affect how much consumers spend on durable and non-durable goods. Borrowers can face both loan-to-value (LTV) constraints and payment-to-income (PTI) constraints. In this setting, a monetary contraction drastically reduces the amount consumers can borrow to purchase durable goods. We examine these effects in a dynamic stochastic general equilibrium (DSGE) model. DSGE models with durables predict that when monetary policy tightens, non-durable consumption will fall and durable consumption will rise. But this prediction contradicts empirical evidence, which shows that both types of consumption fall, and durables fall more than non-durables. Studies have tried to resolve this puzzle by integrating LTV constraints into the model, but without much success. In our model, we use a broader set of financial frictions that includes PTI limits on borrowing. We show that using both LTV and PTI constraints in the model solves the counterfactual increase in durables following a contractionary monetary shock and delivers the correct correlation. Including the PTI limit in the model leads to a decrease in labour supply. This reduces output, which, in turn, makes it more likely that total durable expenditures will fall.

Keywords: Financial system regulation and policies; Monetary Policy (search for similar items in EconPapers)
JEL-codes: E44 E52 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge, nep-mac, nep-mon and nep-ore
Date: 2019-08
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Handle: RePEc:bca:bocawp:19-31