Zheng Liu, Pengfei Wang, and Tao Zha
Working Paper 2010-1
February 2010

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Previous studies on financial frictions have been unable to establish the empirical significance of credit constraints in macroeconomic fluctuations. This paper argues that the muted impact of credit constraints stems from the absence of a mechanism to explain the observed persistent comovements between housing prices and business investment. We develop such a mechanism by incorporating two key features into a dynamic stochastic general equilibrium model: We identify shocks that shift the demand for collateral assets and allow productive agents to be credit-constrained. A combination of these two features enables our model to successfully generate an empirically important mechanism that amplifies and propagates macroeconomic fluctuations through credit constraints.

JEL classification: E21, E27, E32

Key words: credit constraints, collateral asset, housing prices, investment, financial multiplier, business cycle, structural estimation

For help discussions and comments, the authors thank Susanto Basu, Larry Christiano, Marty Eichenbaum, John Fernald, Kris Gerardi, Mark Gertler, Mike Golosov, Pat Higgins, Matteo Iacoviello, Nobu Kiyotaki, Dirk Krueger, Junior Maih, Jim Nason, Lee Ohanian, Alberto Oritz-Bolanos, Richard Rogerson, Julio Rotemberg, Tom Sargent, Frank Schorfheide, Mark Spiegel, Harald Uhlig, Dan Waggoner, Carl Walsh, John Williams, and seminar participants at the Federal Reserve Banks of Atlanta and San Francisco, the 2009 National Bureau of Economic Research Summer Workshop on Impulse and Propagation Mechanisms, the University of Pennsylvania, the University of Wisconsin, Georgetown University, the University of Southern California and the University of California (UC), Los Angeles, UC San Diego, UC Riverside, UC Santa Cruz, and UC Davis. They also thank David Lang, Jacob Smith, and Diego Vilán for research assistance and Anita Todd for editorial assistance. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Zheng Liu, Research Department, Federal Reserve Bank of San Francisco, 101 Market Street, MS 1130, San Francisco, CA 94105, 415-974-3328, zheng.liu@sf.frb.org; Pengfei Wang, Department of Economics, Hong Kong University of Science and Technology, Clearwater Bay, Kowloon, Hong Kong, pfwang@ust.hk; or Tao Zha, Research Department, Federal Reserve Bank of Atlanta and Emory University, 1000 Peachtree Street, N.E., Atlanta, GA 30309-4470, 404-498-8353, tzha@earthlink.net.

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