'Real-World' Mortgages, Consumption Volatility and the Low Inflation Environment

49 Pages Posted: 19 Oct 2005

See all articles by Sebastian Barnes

Sebastian Barnes

Bank of England - Monetary Analysis

Gregory Thwaites

Bank of England - Monetary Analysis

Date Written: September 2005

Abstract

This paper considers the interaction between the microeconomic decisions facing households and the macroeconomic environment in a setting where households have 'real-world' mortgage contracts. In particular, we consider the possible consequences of the important changes in the framework for setting monetary policy in the United Kingdom in recent decades that have coincided with a more stable and low inflation environment. We set a model of households with 'real-world' mortgages in a partial equilibrium overlapping generations framework calibrated to UK data. We find that the welfare gains of the change of regime would have been considerable. However, the baseline calibration of the model implies that the volatility of aggregate consumption growth would actually be higher in the steady state in the more stable environment of the 1990s regime. This is due to greater synchrony in the response of households to shocks, offsetting the smaller magnitude of macroeconomic shocks. This effect is amplified by higher levels of debt in the 1990s. The result that aggregate consumption volatility could be higher in the current regime suggests that the observed fall in aggregate consumption volatility cannot necessarily be attributed to the more stable macroeconomic environment and the role of mortgage debt. If this result applies, this would suggest that the observed fall in volatility may be due either to other factors or may be a transitional phenomenon rather than a feature of the new steady state.

Keywords: Household consumption, household portfolios, mortgage choice, housing, monetary policy regimes, overlapping generations

JEL Classification: D11, D14, E21, E42

Suggested Citation

Barnes, Sebastian and Thwaites, Gregory, 'Real-World' Mortgages, Consumption Volatility and the Low Inflation Environment (September 2005). Bank of England Working Paper Series No. 273, Available at SSRN: https://ssrn.com/abstract=824746 or http://dx.doi.org/10.2139/ssrn.824746

Sebastian Barnes

Bank of England - Monetary Analysis ( email )

Threadneedle Street
London EC2R 8AH
United Kingdom

Gregory Thwaites (Contact Author)

Bank of England - Monetary Analysis ( email )

Threadneedle Street
London EC2R 8AH
United Kingdom

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