How Should Monetary Policy Respond to Housing Inflation?

Bianchi, Javier; McKay, Alisdair; Mehrotra, Neil

doi:10.21034/wp.808

Working Paper

How Should Monetary Policy Respond to Housing Inflation?

Abstract: A persistent rise in rents has kept inflation above target in many advanced economies. Optimal policy in the standard New Keynesian (NK) model requires policy to stabilize housing inflation. We argue that the basic architecture of the NK model—that excess demand is always satisfied by producers—is inappropriate for the housing market, and we develop a matching framework that allows for demand rationing. Our findings indicate that the optimal response to a housing demand shock is to stabilize inflation in the non-housing sector while disregarding housing inflation. Our results hold exactly in a version of the model with costless search and quantitatively in a version with housing search costs calibrated to match US data on housing tenure, vacancy rates, and the size of the real estate sector.

Keywords: Housing; Monetary policy; Stabilization policy; Inflation;

JEL Classification: E24; E30; E52;

https://doi.org/10.21034/wp.808