Monetary Policy Rules in the Presence of an Occasionally Binding Borrowing Constraint

Monetary Policy Rules in the Presence of an Occasionally Binding Borrowing Constraint Punnoose Jacob Christie Smith Fang Yao Oct 214, Wellington Reserve Bank of New Zealand.

Research Question How does an occasionally-binding Loan-to-Value Ratio (LVR) constraint affect the conduct of monetary policy in terms of an interest rate rule?

Local Context New Zealand s LVR restrictions were introduced on 1 October 213, responding to

Local Context New Zealand s LVR restrictions were introduced on 1 October 213, responding to Annual NZ house price inflation reached 1 percent, December 213 (16% in Auckland).

Local Context New Zealand s LVR restrictions were introduced on 1 October 213, responding to Annual NZ house price inflation reached 1 percent, December 213 (16% in Auckland). The proportion of high LVR lending exceeded 3% in early 213. Housing market led to financial stability concerns

Contribution We start from Iacoviello (25)

Contribution We start from Iacoviello (25) Housing market

Contribution We start from Iacoviello (25) Housing market Patient and impatient households

Contribution We start from Iacoviello (25) Housing market Patient and impatient households Borrowing constraint on loans

Contribution We start from Iacoviello (25) Housing market Patient and impatient households Borrowing constraint on loans Our extensions

Contribution We start from Iacoviello (25) Housing market Patient and impatient households Borrowing constraint on loans Our extensions Open economy DSGE model for NZ

Contribution We start from Iacoviello (25) Housing market Patient and impatient households Borrowing constraint on loans Our extensions Open economy DSGE model for NZ Occasionally-binding borrowing constraint

Main Findings Imposing an occasionally-binding LVR makes the economy respond asymmetrically to positive and negative shocks.

Main Findings Imposing an occasionally-binding LVR makes the economy respond asymmetrically to positive and negative shocks. The LVR affects macro volatilities and hence changes monetary policy.

Main Findings Imposing an occasionally-binding LVR makes the economy respond asymmetrically to positive and negative shocks. The LVR affects macro volatilities and hence changes monetary policy. The optimal monetary policy rule under an LVR constraint transfers welfare from savers to borrowers.

THE MODEL

Households problem Maximise expected utility subject to 1 Budget constraint

Households problem Maximise expected utility subject to 1 Budget constraint 2 Collateral constraint R l,t L t [ µ E t qh,t+1 P c,t+1 h t ]

The Rest of the Model Banks channel savings from domestic and foreign savers to borrowers. Home good produced with capital and Labour Sold at home and abroad Foreign output, inflation and the interest rate: New Keynesian closed economy model

Monetary and LVR Policy Interest rate rule ( ) R rr [( ) rπ ( ) r y ] 1 rr t R = Rt 1 πc,t yt exp ω r,t R π c y t 1

Monetary and LVR Policy Interest rate rule ( ) R rr [( ) rπ ( ) r y ] 1 rr t R = Rt 1 πc,t yt exp ω r,t R π c y t 1 LVR policy R l,t L t [ µ LVR E t qh,t+1 P c,t+1 h t ]

Parameter Values Most of structural parameters are calibrated to match NZ data. The rest are estimated using Bayesian methods Sample period:1993 Q4 to 213 Q3 before the LVR restriction was introduced. The estimated model does not have the borrowing constraint. 9 data series : GDP growth, Consumption growth, Residential investment growth, Business investment growth, Housing loan growth, 9-day rate, CPI inflation, House price Inflation, Mortgage spread.

Occasionally-Binding Solution

Occasionally-binding Solution We use the "OccBin" Toolbox developed by Guerrieri and Iacoviello (214) A piecewise-linear approximation of occasionally binding constraints It is able to deal with large models with many predetermined variables.

% from S.S. Asymmetric IRFs: Monetary Policy Shock Contractionary 2 9 Day Rate 1 House Price Loan O utput CPI Inflation 1 1.5 1.5 1 2 1.5 1 4q 8q 2 4q 8q 3 4q 8q 2 4q 8q 1 4q 8q Occasionally binding P erpetually binding

% from S.S. % from S.S. Asymmetric IRFs: Monetary Policy Shock Contractionary 2 9 Day Rate 1 House Price Loan O utput CPI Inflation 1 1 1.5 1 2 1 4q 8q 2 4q 8q 3 4q 8q 2 4q 8q 1 4q 8q Occasionally binding Perpetually binding Expansionary 1 9 Day Rate 2 House Price 3 Loan 2 O utput 1 CPI Inflation 1 2 1.5 1 1 2 4q 8q 1 4q 8q 4q 8q 4q 8q 4q 8q

Stochastic Simulation

Stochastic Simulation Comparing Moments from the Perpetually- and Occasionally-binding Models Binding Frequency Output S.D. (%) CPI Inflation S.D. (%) LVR Occasional Perpetual Occasional Perpetual Occasional Perpetual.9 1.4% 1%.77 1.13.19.21.7 12% 1%.75.87.18.19

Optimal Policy

Optimal Monetary Policy Rules Taylor Rules Estimated: ˆR t =.8 ˆR t 1 +.2 (1.89 ˆπ c,t +.32 ŷ t ) Occ.binding optimal: ˆR t =.8 ˆR t 1 +.2 (1.1 ˆπ c,t ŷ t ) Always binding optimal: ˆR t =.8 ˆR t 1 +.2 (3 ˆπ c,t ŷ t )

Welfare Evaluation Welfare Level (Gain in terms of consumption) Taylor Rules Saver Borrower Social Estimated: -84.83-11.42-1.912 Occ.binding: -85.88 ( 1.4%) -1.71 (.71%) -1.91 (.2%) Always binding: -75.4 (9.8%) -113.12 ( 11.6%) -2.1 (.2%)

Level Temporary LVR Tightening.92.91 Loan to Value Ratio Occasionally binding Perpetually binding.9.89.88.87 8q 16q 24q 32q 4q 48q

% from S.S. Annualised % Annualised Level in % Level % from S.S. % from S.S. Temporary LVR Tightening.92 Loan to Value Ratio 1 Loans.1 House Price.91.5.9.89.1.88.5.2.87 8q 16q 24q 32q 4q 48q 1 8q 16q 24q 32q 4q 48q.3 8q 16q 24q 32q 4q 48q.5 Output.3 Inflation 5.4 Policy rate.2 5.2.1 5.5 Occasionally binding Perpetually binding 1 8q 16q 24q 32q 4q 48q.1 8q 16q 24q 32q 4q 48q 4.8 4.6 8q 16q 24q 32q 4q 48q

Conclusion We study macro dynamics under an occasionally-binding LVR. The LVR makes the economy respond asymmetrically to positive and negative shocks and hence changes macro volatilities and monetary policy. Future Research: Extend monetary policy rule to include house price inflation and credit growth Endogenise LVR policy Open economy dimensions

Bank s problem Bank dividend Budget constraint max E t β τ λ t+τ D b,t+τ (j) b (1) τ= λ t P c,t+τ D b,t (j) P c,t S t (j) P c,t + R t 1S t 1 (j) P c,t + S t (j) e t P c,t + R l,t 1L t 1 (j) P c,t + Φ t 1R t 1 S t 1 (j) e t P c,t + L t (j) P c,t The bank is subject to a capital requirement constraint L t (j) S t (j) St (j)/e t = 1 µ L t (j) b,t ( ) bl where : µ b,t = µ b (1 b b Lt b ) b,t 1, b P d,t y l >, b b [, 1) d,t <

% from S.S. % from S.S. % from S.S. IRFs to Monetary Policy Shock Shock Process Policy R ate C P I Inflation O utput 1.2 97.5% ile.2 Median 2.5% ile.5.2.2.4.1.4.6.5.6.8 4q 8q 12q 16q 2q 4q 8q 12q 16q 2q 4q 8q 12q 16q 2q 4q 8q 12q 16q 2q C ons. Saver C ons. Borrower H ousing Inv. H ouse Price.5.5.5.2.5.4.5 1 1.6 1 1.5 1.5.8 1.5 4q 8q 12q 16q 2q 4q 8q 12q 16q 2q 4q 8q 12q 16q 2q 4q 8q 12q 16q 2q Loans Lending Spread Business Inv. RER.3 1.5.2.2 1.4.1.5.5.6.8.1 4q 8q 12q 16q 2q 4q 8q 12q 16q 2q 1.5 4q 8q 12q 16q 2q 4q 8q 12q 16q 2q

Optimal Monetary Policy Rules under LVR We evaluate Taylor type operational rules based on unconditional expectations of social welfare. Due to the occasionally binding constraint, we apply a simulation-based welfare measure. We simulate the model based on estimated parameters and driving forces for 5 periods, repeating it for 2 times. Averaging across 2 replications yields a sample approximation to the expected values of variables for the welfare measure. We repeat this exercise for each candidate policy rule on a grid of Taylor rule coeffi cients.