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Monetary Policy, Residential Investment, and Search Frictions: An Empirical and Theoretical Synthesis

Using a factor-augmented vector autoregression (FAVAR), this paper shows that residential investment contributes substantially to GDP following monetary policy shocks. Further, it shows that the number of new housing units built, not changes in the sizes of existing or new housing units, drives residential investment fluctuations. Motivated by these results, this paper develops a dynamic stochastic general equilibrium (DSGE) model where houses are built in discrete units and traded through searching and matching. The search frictions transmit shocks to housing construction, making them central to producing fluctuations in residential investment. The interest rate spread between mortgages and risk-free bonds also transmits monetary policy to the housing market. Following monetary shocks, the DSGE model matches the FAVAR’s positive co-movement between nondurable consumption and residential construction spending. In addition, the FAVAR shows that the mortgage spread falls following an expansionary monetary shock, providing empirical support for the DSGE model’s monetary transmission mechanism.

Keywords: Factor-augmented vector autoregression, interest rate spread, monetary policy, residential investment, search theory.

JEL Codes: C32, E30, E40, E50, R31.

Suggested citation: Lunsford, Kurt G., 2016. “Monetary Policy, Residential Investment and Search Frictions: An Empirical and Theoretical Synthesis,” Federal Reserve Bank of Cleveland Working Paper, no. 16-07.

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