Date Added: Feb 2010
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. The authors develop such a mechanism by incorporating two key features into a dynamic stochastic general equilibrium model: They identify shocks that shift the demand for collateral assets and allow productive agents to be credit-constrained. A combination of these two features enables the model to successfully generate an empirically important mechanism that amplifies and propagates macroeconomic fluctuations through credit constraints.