Should Central Bank respond to the Changes in the Loan to Collateral Value Ratio and in the House Prices?

Paper number: 13/03

Paper date: 24 April 2013

Year: 2013

Paper Category: Discussion Paper

Authors

Tatiana Damjanovic and Sarunas Girdenas

Abstract

We study optimal policy in a New Keynesian model at zero bound interest rate where households use cash alongside with house equity borrowing to conduct transactions. The amount of borrowing is limited by a collateral constraint. When either the loan to value ratio declines or house prices fall we observe decrease in the money multiplier. We argue that the central bank should respond to the fall in the money multiplier and therefore to the reduction in house prices or in the loan to collateral value ratio. We also find that optimal monetary policy generates large and more persistent fall in the money multiplier in response to drop in the loan to collateral value ratio.

Keywords: optimal monetary policy, money supply, money multiplier, loan to value ratio, collateral constraint, house prices, zero bound interest rate

JEL classification: E44, E51, E52, E58

Should Central Bank respond to the Changes in the Loan to Collateral Value Ratio and in the House Prices? Should Central Bank respond to the Changes in the Loan to Collateral Value Ratio and in the House Prices?