Non-Ricardian Borrowers and Mortgage Type: Implications for Monetary Policy Leaning against the Wind

Abstract

Leaning against the wind of credit booms is a monetary policy that is tighter than what is consistent with standard inflation targeting. This way the central bank tries to address excessive household debt. While the merits of such policy have been analysed, I argue that there are two dimensions that have been overlooked but are crucial: (i) ability of borrowers to freely adjust outstanding debt (refinancing) and (ii) dominant mortgage type in the economy (fixed or adjustable rate). I answer the research question using a standard macroeconomic model extended for the presence of borrowers who consume all their disposable income (hand-to-mouth) net of payments on long-term mortgage. I find that the optimal simple policy rule significantly depends on the ability to adjust debt and on mortgage type. Policy prescriptions based on models not accounting for these realistic features may lead to wrong monetary decisions.