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Failure to Launch: Housing, Debt Overhang, and the Inflation Option During the Great Recession

Aaron Hedlund

No 1515, Working Papers from Department of Economics, University of Missouri

Abstract: Can inflating away nominal mortgage liabilities cure debt overhang and combat a severe housing bust? With a focus on the Great Recession, I address this question using a structural macroeconomic model of illiquid housing, endogenous credit supply, and equilibrium default. First, I show that the model successfully replicates and provides insight into the dynamics of the U.S. economy since 2006. Second, I show that temporarily raising the inflation target would have cut foreclosures by over 60% and led to a more robust recovery in real economic variables. Price-level targeting that promises to offset this temporary inflation with future disinflation has more modest positive effects. In short, forward guidance matters. Higher inflation loses its potency in the counterfactual where all homeowners have adjustable rate mortgages, which highlights the importance of nominal rigidities for the e?ectiveness of these policies. Lastly, inflation proves effective even if wages exhibit substantial nominal stickiness.

Keywords: Housing; Liquidity; Mortgage Debt; Foreclosure; Inflation (search for similar items in EconPapers)
JEL-codes: D31 D83 E21 E22 G11 G12 G21 R21 R31 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge, nep-mac and nep-ure
Date: 2015-10-16
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