Failure to Launch: Housing, Debt Overhang, and the Inﬂation Option During the Great Recession
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Can inﬂating away nominal mortgage liabilities cure debt overhang and combat a severe housing bust? With a focus on the Great Recession, I address this question using a structural macroeconomic model of illiquid housing, endogenous credit supply, and equilibrium default. First, I show that the model successfully replicates and provides insight into the dynamics of the U.S. economy since 2006. Second, I show that temporarily raising the inﬂation target would have cut foreclosures by over 60% and led to a more robust recovery in real economic variables. Price-level targeting that promises to oﬀset this temporary inﬂation with future disinﬂation has more modest positive eﬀects. In short, forward guidance matters. Higher inﬂation loses its potency in the counterfactual where all homeowners have adjustable rate mortgages, which highlights the importance of nominal rigidities for the eﬀectiveness of these policies. Lastly, inﬂation proves eﬀective even if wages exhibit substantial nominal stickiness.