Failure to Launch: Housing, Debt Overhang, and the Inflation Option During the Great Recession

Working Paper Number: 
WP 15-15

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.

JEL Codes: 
D31, D83, E21, E22, G11, G12, G21, R21, R31