Housing and endogenous default

This paper examines credit market imperfections in a New Keynesian model with housing. Unlike in the related literature, households may default on their debt if housing prices are sufficiently low, potentially resulting in a temporary loss of access to credit or housing markets. We find that allowing for actual default, as opposed to just the threat of default, has important implications for the model’s behavior. Default has three conflicting significant effects on borrowers. First, the loss of access to housing markets provides borrowers with an incentive to substitute toward consumption. Second, default transfers wealth from lenders to borrowers. Third, the loss of access to credit markets prevents them from smoothing their consumption, resulting in decreased consumption. In a general equilibrium version of the model where agents form expectations under adaptive learning, the former effects dominate and borrowers respond to default by increasing their consumption. However both aggregate and lenders’ consumption decreases in the default state. We also show that the nature of default matters. If unpaid debt is simply written off, without an accompanying loss of access to either housing or credit markets, then default does not have discrete effects. It is thus the lack of borrower access to housing and credit markets that makes default interesting.

Furthermore, we also show that the effects of default are smaller if borrowers are able to maintain access to housing, but not credit markets. In addition, the distortion of the housing market causes the initial decline in housing prices to be amplified. Despite the recent volatility in housing markets, this paper, to the best of our knowledge, is the first to examine the effects of actual default in a New Keynesian framework.