How Does Liquidity Constraint Affect Employment and Wages? Evidence from Danish Mortgage Reform

Abstract

This paper studies the effects of liquidity constraints on employment and earnings by exploiting a mortgage reform in Denmark in 1992, which for the first time allowed homeowners to borrow against housing equity for non-housing purposes. We find that liquidity-constrained homeowners extracted housing equity, increased debt levels and experienced higher earnings growth after the reform. In contrast, the reform had little impact on employment and earnings of homeowners with high liquid asset holdings. Consistent with models of job search with risk aversion, the option to borrow against housing equity allows individuals to seek jobs that have higher earnings growth but higher unemployment risks. This effect is larger for low-income and older individuals. The results imply that relaxing liquidity constraints can increase output, and policies restricting mortgage refinancing during economic distress may backfire in recessions.

JEL Classification: G21, E44, E24, J60, D14, R20