Homework in Monetary Economics: Inflation, Home Production and Production of Homes

S. Boragan Aruoba, Morris A. Davis and Randall Wright, Review of Economic Dynamics, November .


We introduce household production and the production of houses (construction) into a monetary model. Theory predicts infl‡ation, as a tax on market activity, encourages substitution into household production and hence investment in housing. In the model, the stock and appropriately-de‡flated price of housing increase with infl‡ation or nominal interest rates. We document this in data for the U.S. and other countries. A calibrated model accounts for up to 52% (87%) of the relationship between interest rates and housing wealth defl‡ated by nominal output (by the money supply). It also implies the cost of infl‡ation is higher than in models without home production.

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