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Nonlinear Effects of Loan-to-Value Constraints

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Abstract
This paper investigates the impact of loan-to-value (LtV) borrowing constraints in models with occasionally binding credit constraints. These constraints give rise to a Fisherian debt-deflation mechanism, where exogenous shocks can trigger cascading effects resulting in significant declines in consumption, asset prices, and borrowing reversals—characteristic of financial crises. However, recent literature challenges traditional view by suggesting that collateral constraints may not always exacerbate financial disturbances but could instead foster dynamics leading to multiple equilibria. Building on this discussion, the paper explores equilibrium asset pricing models with LtV collateral constraints, identifying critical thresholds that govern asset price dynamics, consumption patterns, and current account behaviors. Our analysis uncovers that when the LtV limit is close to zero, tighter constraints induce smaller drops in consumption during crises. Conversely, when the LtV limit is close to one, we observe that tighter constraints induce larger drops in consumption during crises. The nonlinear relationship between the LtV ratio and adverse effects on macroeconomic outcomes aligns with cross-country evidence regarding the relationship between the level of financial development and the severity of consumption declines during crises.

Suggested Citation

  • Bora Durdu & Sergio Villalvazo, 2024. "Nonlinear Effects of Loan-to-Value Constraints," Finance and Economics Discussion Series 2024-081, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2024-81
    DOI: 10.17016/FEDS.2024.081
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    References listed on IDEAS

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    1. Enrique Mendoza & Sergio Villalvazo, 2020. "FiPIt: A Simple, Fast Global Method for Solving Models with Two Endogenous States & Occasionally Binding Constraints," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 37, pages 81-102, July.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Financial crises; Loan-to-value constraints; Debt-deflation;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G01 - Financial Economics - - General - - - Financial Crises

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