Question

In France and Germany, it is difficult for a household to increase its borrowing based on an increase in the market value of the house. In addition, large down-payments (as a percentage of the house price) are required for house purchases. 3. What do you conclude about the role of the financial accelerator in France and Germany compared with the UK and the US?

Answer 1

The key idea behind the financial accelerator is the notion that shocks to the net worth of firms and households have a procyclical effect on their borrowing capacity. This can happen either because the information cost wedge between external and internal finance moves countercyclically or because a procyclical change in the value of collateralizable assets changes the external financing capacity in the same direction. Following a positive income shock, agents should be able to raise more external finance, and the increase in their borrowing capacity would further boost spending. According to this view, the endogenous procyclicality of the external financing capacity of firms and individuals can help explain important features of the business cycle and the transmission of monetary policy.

Now lets see the example of UK and US, the countries withhigher the LTV (Loan to Value) ratio. The presence of a maximum LTV ratio affects prices in the housing market. If the households receive a positive income shock it boosts housing prices. If the househould is in a country like US and UK, the higher the LTV (Loan to Value) ratio that households can achieve, the higher the increase in borrowing capacity that is generated by the ensuing increase in prices. Over this, the procyclical increase in borrowing capacity may allow households to further increase housing spending, amplifying the collateralbased spending cycle. If an accelerator effect is present, then housing prices should respond more to the initial income shock when the maximum LTV is high. In this fashion, the relation between LTV ratios and the income sensitivity of housing prices provides for a direct test of the endogenous mechanism underlying the financial accelerator: the impact of shocks to household income on housing prices is amplified by the higher marginal opportunity to borrow associated with a high LTV ratio whereas for the countries like France and Germany where the LTV ratio is low, the impact of shocks to household income on housing prices is quite low.

In addition to this, the price effect of the income shocks is amplified through changes in the demand for mortgage debt. This meand that if the effect of LTV ratios on housing prices is generated by a credit multiplier, then new mortgage borrowings should also be more sensitive to income shocks in countries like UK and US with higher maximum LTVs