Collateral Constraints in a Monetary Framework with Flexible Prices

This paper discusses the effects of asset price volatility on loan and aggregate output in a utility-based approach. In a real dynamic economy with heterogeneous agents, the creditdebt relationship is endogenously determined, given that borrowers are more productive but subject to collateral constraints. Resource allocation among borrowers and lenders affects the aggregate output as well as asset prices. The dynamic interaction of asset prices and loan generates a powerful transmission mechanism, through which the effects of a small temporary productivity shock on the aggregate output amplify and persist. By implicitly introducing money and assuming that government follows an interest rate rule with forward-looking inflation targeting, a temporary shock does not affect the resource allocation among agents and the aggregate output in a monetary dynamic economy with flexible nominal prices. In fact, the monetary economy is insulated from the supply-side shock via the endogenous dynamics of the effective debt burden. Partial indexation of nominal debts only affects inflation and nominal interest rates. If government follows an interest rate rule with current-looking inflation targeting, a temporary shock affects asset allocation among agents similar to that in the real economy and its magnitude is positively related to the weight that government puts on the inflation gap in the policy rule. Partial indexation of nominal debts enhances the asset reallocation. ∗Center for European Integration Studies (ZEI), Bonn Graduate School of Economics, University of Bonn, Walter-Flex-Str.3, 53113, Bonn, Germany. Tel: 0049 228 73 1979, [email protected]. I am grateful to Jürgen von Hagen, Nobu Kiyotaki, Christopher Waller, Jizhong Zhou and all seminar participants in ZEI for helpful advices. All remaining errors are my own responsibility.