Working Paper: CEPR ID: DP8381
Authors: Virgiliu Midrigan; Thomas Philippon
Abstract: A salient feature of the recent U.S. recession is that output and employment have declined more in regions (states, counties) where household leverage had increased more during the credit boom. This pattern is difficult to explain with standard models of financing frictions. We propose a theory that can account for these cross-sectional facts. We study a cash-in-advance economy in which home equity borrowing, alongside public money, is used to conduct transactions. A decline in home equity borrowing tightens the cash-in-advance constraint, thus triggering a recession. We show that the evidence on house prices, leverage and employment across US regions identifies the key parameters of the model. Models estimated with cross-sectional evidence display high sensitivity of real activity to nominal credit shocks. Since home equity borrowing and public money are, in the model, perfect substitutes, our counter-factual experiments suggest that monetary policy actions have significantly reduced the severity of the recent recession.
Keywords: cash-in-advance; household credit; housing leverage; monetary policy; recession
JEL Codes: E2; E4; E5; G0; G01
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| decline in home equity borrowing (G51) | tightening of cash-in-advance constraints (E41) |
| tightening of cash-in-advance constraints (E41) | trigger a recession (E32) |
| monetary policy interventions (E52) | reduced severity of recession (E65) |
| household leverage increase (G59) | decline in nondurable consumption (D12) |
| household leverage increase (G59) | decline in durable consumption (E21) |
| Federal Reserve intervention (E52) | non-construction employment drop (J69) |
| household leverage increase (G59) | decline in employment (J63) |
| household leverage increase (G59) | decline in output (E23) |