Monetary Policy and Household Net Worth

Abstract This paper investigates the interrelation between household balance sheets, collateral constraints, and monetary policy. Using data on the U.S. economy, we estimate a monetary DSGE model with financial frictions and occasionally binding borrowing constraints. The model implies stronger effects of monetary policy interventions when the borrowing constraint is binding compared to situations when it turns slack. In a prediction analysis we find that, out of a set of alternative plausible endogenous model variables, the level of household net worth is the single best predictor of the tightness of the borrowing constraint, which implies that monetary policy is more effective when household net worth is low. We test this model prediction in the data and provide robust empirical evidence on asymmetric effects of monetary policy across the household net worth cycle that validates the model predictions. A contractionary monetary policy shock leads to a large and significant fall in economic activity during periods of low household net worth. In contrast, monetary policy shocks have only small and mostly insignificant effects when net worth is high.