Household Leverage and the Recession

Abstract

A salient feature of the recent recession is that regions that have experienced the largest changes in household leverage have also experienced the largest declines in output and employment. We study a cash-in-advance economy in which home equity borrowing, alongside public money, is used to conduct transactions. Declines in home prices tighten the cash-in-advance constraint, triggering recessions. We parameterize the model to match the key cross-sectional features of the data. The model implies that real activity is very sensitive to liquidity shocks, but not to credit shocks, and that monetary policy can significantly reduce the severity of credit-driven recessions.