DP13400 House Price Dynamics, Optimal LTV Limits and the Liquidity Trap

Author(s): Andrea Ferrero, Richard Harrison, Benjamin Nelson
Publication Date: December 2018
Keyword(s): financial crisis, monetary and macro-prudential policy, zero lower bound
JEL(s): E52, E58, G01, G28
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13400

The inception of macro-prudential policy frameworks in the wake of the global financial crisis raises questions about the effects of the newly available policy tools and their interaction with the existing ones. We study the optimal setting of a loan-to-value (LTV) limit, and its implications for optimal monetary policy, in a model with nominal rigidities and financial frictions. The welfare-based loss function implies a role for macro-prudential policy to enhance risk-sharing. Following a house price boom-bust episode, macro-prudential policy alleviates debt-deleveraging dynamics and prevents the economy from falling into a liquidity trap. In this scenario, optimal policy always entails countercyclical LTV limits, while the response of the nominal interest rate depends on the nature of the underlying shock driving house prices.