Should Debt and Housing Market Dynamics Affect Monetary Policy? Lessons from Sweden 1992-2015

Sammanfattning: In this study, it will be investigated whether housing market dynamics and private indebtedness should be included in the Swedish Riksbank's formulation of monetary policy according to its mission of flexible inflation targeting. A basic model of the supply and demand sides will be chosen. This model includes a representation of the goods market equilibrium, short-run aggregate supply (SRAS) curve and expectations-augmented Phillips curve tied together through a representation of Okun's Law. Furthermore, the goals of the Riksbank will be given an analytical and mathematical interpretation in terms of a social loss function. Given the model and the social loss function an optimal rate-setting rule will be calculated. This set of models will then be used in regressions to make empirical inferences with respect to the Riksbank's view of social loss. In the next step, an alternative representation of the goods market equilibrium will be derived from a basic model regarding debt and housing market dynamics. This other goods market equilibrium will therefore include measures of private indebtedness and housing market dynamics. Using this new version of the equilibrium, an alternative rate-setting regime will be derived. Then by employing the empirical inferences regarding the Riksbank's view of social loss in the previous step and the alternative rate-setting rule in this step, counterfactual simulations of economic measures (i.e. inflation, unemployment rate, GDP, and the repo rate) will be produced. Based on these simulations, some conclusions will be drawn regarding the prudence of including housing market dynamics and private indebtedness into the model. The operational paradigm is Keynesian using forward-looking and rational expectations and the data concerns Sweden 1992Q1-2015Q4. Results largely indicate that housing market and debt dynamics should not be included in rate-setting deliberations by the Riksbank.