Real estate and optimal public policy in a credit-constrained economy

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Abstract

This paper articulates a general equilibrium model of a two-sector economy where entrepreneurs borrow from households subject to a credit constraint. Real estate is a productive factor in the entrepreneurial sector and serves as collateral in entrepreneurs’ debt contracts. We consider two types of public policies that have the potential of improving upon the economy’s equilibrium outcome, one of subsidizing entrepreneurial real estate holding and the other subsidizing household interest income. It is found that the former policy opens up a wide range of possibilities for Pareto improvement when the supply of real estate is endogenous.

Introduction

An important fact in the economy is that agents are separated into different types—entrepreneurs and households for example. In this paper we highlight a linkage between these two type of agents, which is the borrowing–lending relationship. In particular, entrepreneurs borrow from households to fulfill their need for funds. Real estate plays dual roles for the entrepreneurial sector. It is a productive factor input and it also serves as collateral in the entrepreneurs’ debt contracts. Entrepreneurs’ borrowing and therefore their economic activities, including purchasing labor from the household sector, are constrained by the market value of the real estate they own. This paper articulates a general equilibrium model of such an economy and raises the following question. Is the unintervened outcome of this economy optimal? Is there scope for public policy to improve upon the general equilibrium outcome in this economy? We consider two types of policies, one of subsidizing entrepreneurial real estate ownership, the other subsidizing household interest income. It is found that these policies have the potential to raise at least some welfare measures of the economy. Importantly, the former policy opens up a wide range of possibilities for Pareto improvement when the supply of real estate is endogenous.

Understanding the effects of these policies hinges critically on recognizing the fact that entrepreneurs’ borrowing limit is positively related to the market value of their real estate holding and inversely related to the interest rate. The policy of subsidizing entrepreneurial real estate ownership, equivalent to a negative property tax, effectively lowers the depreciation rate for entrepreneurial real estate. It stimulates entrepreneurs’ real estate demand and bids up real estate price, allowing entrepreneurs to borrow more, hire more labor, and produce more output. The policy of subsidizing household interest income directly lowers the interest rate faced by entrepreneurs, drives up real estate price, and redistributes real estate holding from the household sector to the entrepreneurial sector, causing output to increase in equilibrium. Our results indicate that for certain ranges these policies have positive welfare consequence.

There are already many studies that discuss the implications of credit constraints for economic performance. Prominent examples include Stiglitz and Weiss, 1981, Bernanke et al., 1999, Kiyotaki and Moore, 1997, among others. Yet there is little discussion about what public policy can do in economies with credit constraints on particular types of agents. This paper raises this question and attempts to provide a first-step answer to it. Our consideration of the two policies mentioned above is based on the important roles played by asset holding, asset price, and the interest rate in determining entrepreneurs’ credit limits. Both the policy of subsidizing entrepreneurial real estate ownership and the policy of subsidizing interest income directly impact the discounted collateral value and therefore entrepreneurial borrowing and production. They have important welfare consequences as they influence the economy’s production, consumption, and asset allocation. Since our goal is to find out what the optimal intervention is for economies with credit-constrained entrepreneurs, it occurs natural for us to investigate the effects of both policies. The policy of subsidizing entrepreneurial real estate holding is our emphasis as it has a large potential to bring about Pareto improvement.

Our paper is related to a fast growing literature on the nexus between real estate and the macroeconomy. The literature is coming to a consensus that the real estate market does play an important role in the aggregate economy.2 A couple of channels through which real estate affects the economy have been emphasized. An important one is the wealth effect: as real estate price increases, agents increase their consumption and hence stimulate the macroeconomy. Recent empirical works on this line include Bostic et al., 2005, Case et al., 2005, Edelstein and Lum, 2004, among others. Another channel, more closely related to our paper, is the collateral effect: as real estate price rises, the net worth of credit-constrained agents increases. These agents then raise their consumption and/or investment (in capital or in real estate). Recent works such as Kiyotaki and Moore, 1997, Ortalo-Magne and Rady, 2006, Iacoviello, 2005, Jin et al., 2006, among others, investigate this channel in dynamic general equilibrium settings. In addition, Davis and Heathcote, 2005, Jin and Zeng, 2004 find that real estate is important for understanding business cycle fluctuations.

For tractability, the classification of agents into entrepreneurs versus households is fixed in our paper. There are models, such as Aghion and Bolton, 1997, Banerjee and Newman, 1993, Iyigun and Owen, 1998, Quadrini, 2000, that allow agents to choose their occupations and arrive at an endogenous classification. Like these studies, our paper emphasizes entrepreneurs as a special group and their interaction with other agents through the credit market, labor market, goods market, etc.

The rest of the paper is organized as follows. Section 2 lays out the baseline model where the supply of real estate is exogenously fixed. Optimal public policy within this context is then analyzed in Section 3. Section 4 introduces endogenous supply of real estate and distortionary-tax financing. The last section concludes. All proofs are relegated to the Appendix.

Section snippets

The baseline model

We take the model in Iacoviello (2005, AER) as our benchmark, as it is suitable for many of our purposes. It contains an entrepreneur sector and a household sector, where entrepreneurs borrow from households subject to a credit constraint. Real estate serves as collateral in entrepreneurs’ debt contract. Our analysis differs from his mainly in two respects. First, the Iacoviello model focuses on short-run analysis and aims to generate impulse responses of output, consumption, and house prices

Optimal public policy

We first consider the case where the subsidies on interest income and entrepreneurial real estate holdings are financed by lump-sum taxes. This helps to highlight the social benefits and costs of these policies aside from the additional costs arising from distortionary-tax financing. Thus, in this section, τl = 0. We first analyze the effects of subsidizing entrepreneurial real estate ownership and then the effects of subsidizing interest income (received by households). The first policy amounts

The full model

In the previous analysis we have made the simplifications that asset supply is exogenously fixed and that subsidies on interest income and entrepreneurial real estate holdings are financed by lump-sum tax. In this section we relax these assumptions in order to arrive at a more reliable answer to the question we have posed. Here we assume that the subsidies are financed by tax on labor income, which adds a cost to using these policies. We also allow for endogenous supply of real estate. It will

Conclusions

In this paper we have articulated a general equilibrium model of a two-sector economy where entrepreneurs borrow from households subject to a credit constraint, with their real estate serving as collateral in their debt contracts. Undertaking policy analysis using this model has the advantage of capturing general equilibrium, rather than partial equilibrium, effects of the policies in question. We have highlighted the effects of the two subsidy policies we consider on asset price, real estate

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Cited by (0)

We thank Martin Feldstein, James Poterba, Michael Woodford, Justin Yifu Lin, and participants of the NBER-CCER Annual Conference 2006 for insightful comments on an earlier draft of the paper. We are also grateful to Paul Anglin, Nan-Kuang Chen, and Charles Ka Yui Leung, and participants of the International Conference on Real Estates and the Macroeconomy for helpful suggestions. Finally, we have benefited from the insightful comments by an anonymous referee. All errors remain ours.

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