The Dependence of the Monetary Policy

Transmission Mechanism to Inflation on the

State of Household Balance Sheets: Evidence
from the Eurozone.
EC424 Structured Research Assignment – Winter Term 2024

Candidate Number: 23193

28 May 2024

Abstract

Following the significant shift in household balance sheets due to forced savings from the pandemic, I
utilise the richer dataset to explore the ‘household wealth channel’ of monetary policy transmission,
where the state of household balance sheets impacts the effectiveness of monetary policy tools. This
paper uses a non-linear local projections approach to model the transmission of policy rates to
aggregate and core inflation within the Eurozone between 2000-2023, incorporating data from the
most recent monetary tightening cycle. The paper finds some evidence of a negative ‘household
wealth channel’ for monetary policy and recommends policymakers consider the effectiveness of their
policy tools dependent on household balance sheets in order to set an optimal path of interest rates.

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1. Introduction
In recent years, society has experienced unprecedented disruptions in the form of the Covid-19
pandemic and the Russian invasion of Ukraine. The former resulted in governments strengthening
income support schemes, with the aim of preserving employment levels, during a period where much
economic activity was curtailed to accommodate social distancing measures. The introduction of
schemes such as the UK’s Coronavirus Job Retention Scheme or the US’s CARES Act as well as the
bolstering of short-time work schemes such as Germany’s Kurzarbeit, meant that household incomes
were heavily cushioned from the pandemic (Scarpetta, Pearson, Hijzen, & Salvatori, 2020). Coupled
with smoothing tendencies against the falling expectations of future income, increased uncertainty and
forced behavioural changes from national restrictions, household saving ratios rose 12 percentage
points, with 11 percentage points being attributed to forced savings (Dossche & Zlatanos, 2020).
Figure 1 shows a marked difference in the propensity to save for Eurozone households resulting from
the pandemic compared to preceding years.

Figure 1 – Eurozone Household Savings Metrics (Source: Dossche & Zlatanos (2020))

The pandemic’s effect was not limited to household saving ratios but measures across the balance
sheet such as housing wealth, deposits, and debt levels to name but a few. Figure 2 shows the heavy
fluctuations in quarter-on-quarter growth rates of nominal financial net worth with variations reaching
above 6% in the first quarter of 2020.

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 Figure 2 – Quarterly fluctuations of household financial net worth – ECB (2024)

Following the pandemic, with household balance sheets in a much healthier position, there was a
strong surge in demand-driven inflationary pressures as households began to consume goods and
services that they had been restricted from. This was exacerbated by Covid-19 induced supply chain
disruptions as well as the Russia-Ukraine war that followed (Lane, 2024), leading central banks to
react to strong inflationary pressures in the backdrop of significantly shifted household balance sheets
relative to tightening cycles in 1999-2000 and 2006-07. Understanding how monetary policy tools
react under different states of household balance sheets, has been a popular area of research in the past
few decades. The has been a particular focus on the ‘household wealth channel’ of monetary policy
transmission, however, most papers have concentrated on the debate of this channel with respect to
aggregate demand components as opposed to inflation. It is crucial for monetary policy authorities to
understand the dynamics of monetary policy transmission in targeting inflation and how these differ
with household balance sheet fluctuations, in order to generate accurate forecasts for potential future
policy decisions. This can also be critical for the implementation of monetary policy tools within
currency unions such as the Eurozone, where countries have differed significantly in terms of the state
of household balance sheets (Kozina, Tartamella, & Orestis, 2021).

The theory and evidence surrounding the ‘household wealth channel’ of monetary policy transmission
have been divided, with some arguing that low levels of household debt or high indebtedness led to
stronger effects of monetary policy to aggregate demand, and others saying that highly indebted
households will have a weaker response to expansionary policy as they are subject to high interest
payments or collateral constraints. Hence, in this paper I seek to incorporate the new data available
from the most recent monetary tightening cycle, where there was a significant shift in household
balance sheets with falling leverage and increased savings rates, to understand the dynamics of
monetary policy transmission for inflation targeting. To achieve this I will consider data from the
Eurozone as a whole between 2000-2023 and focus on looking at aggregate inflation across time

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rather than considering the heterogenous inflationary pressures across the euro area countries. This
paper will not focus the heterogeneous impacts for households either, although this is a closely related
question. Furthermore, issues relating to how monetary policy impacts household balance sheets and
the heterogeneity related to these mechanisms are outside the scope of this paper.

The results of this paper show evidence of a negative ‘household wealth channel’ of monetary policy,
where high levels of household wealth led to a weaker monetary policy transmission mechanism to
inflation as proposed by Bernanke, Gertler and Gilchrist (1999). State dependent local projections
using asset and equity-based state variables supported this, whereas liability-based state variables
suffered from a strong correlation with the asset base and hence supported a positive ‘household
wealth channel’ for monetary policy. As a result the paper suggests that monetary policy authorities
must consider the effectiveness of their policy tools dependent on the state of household balance
sheets when deciding the timing and magnitude of policy interventions.

In what follows, I will first review the past literature related to the influence of household balance
sheets to the effectiveness of monetary policy, which debates whether monetary policy generates
larger responses in times of high or low household indebtedness. Then I will look to isolate exogenous
monetary policy shocks in an approach adapted from Romer & Romer (2004) and Murgia (2020) and
apply this series using a local projections approach derived from Jorda (2005) and (Auerbach &
Gorodnichenko (2012), to analyse the path of the response of total and core HICP inflation to
monetary policy when the state of household balance sheets are either side of trend or median levels.
Finally I will conclude with a discussion of my findings, an evaluation of the econometric approach
used to consider the results and highlight potential policy implications.

2. Literature Review
To date, there have been few studies conducted that analyse the influence that household balance
sheets have on monetary policy transmission, with most of these focusing on its transmission to real
economic variables as opposed to analysing the dynamics of monetary policy as an inflation targeting
tool when household balance sheets vary. Nevertheless, the literature surrounding the effectiveness of
monetary policy tools conditional on household debt levels has been divided. On one hand, monetary
policy, in times of high household indebtedness or low net worth, may have amplified effects on
consumption as a result of a ‘financial accelerator’ (Bernanke, Gertler, & Gilchrist, 1999), and as such
will generate larger responses in consumption and real GDP. The ‘financial accelerator’ describes the
effect where expansionary monetary policy stimulates house prices as mortgages to finance house
purchases become cheaper allowing housing demand and price to rise. This increase in house prices
facilitates home equity withdrawals or boosts consumption directly through the wealth effect, which
in turn boosts asset prices feeding the cycle. This effect is stronger when households are highly

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indebted allowing for monetary policy to free up increased home equity. The stronger increases in
consumption levels as a result of expansionary policy during times of high household debt, will
inevitably lead to increased inflationary pressures relative to low household debt states provided the
supply side remains constant. Furthermore, Ozkan et al. (2017) demonstrates that monetary policy is
more effective at stimulating in aggregate demand in high LTV environments as the marginal
propensity to consume for households with loan to value ratios above 85 percent is 42 percent higher
than those with loan to value ratios below the threshold. This supports the negative ‘household wealth
channel’ as highly indebted households are more likely to withdraw home equity to consume, if given
the opportunity to, and high wealth households are likely to save a greater proportion of the lower
interest burden from expansionary policy. Harding and Klein (2022) supports this through a New
Keynesian (NK) model with financial frictions where the model implies stronger monetary policy
interventions when the constraints are binding relative to when they are slack. Furthermore, the paper
employs a similar local projection approach to this paper in order to compare monetary policy
transmission to aggregate demand variables and inflation across states of high or low household net
worth, where they find evidence to support their NK model and a negative ‘household wealth channel’
for monetary policy. This paper looks to extend in part on the empirical aspects of Harding and Klein
(2022) by including data from 2019 onwards, where there was significant variation in household
balance sheets, interest rates and inflation, and expanding the analysis to include different state
variables in order to shed light on different components of the household balance sheet, as well as
applying these techniques to the Eurozone in order to gauge whether hypothesis that high household
net worth leads to a relatively lower response by inflation, is consistent across economies.

However as previously mentioned, the literature on the effect of balance sheets on the ‘household
wealth channel’ of monetary policy transmission is divided where papers such as Eggertsson &
Krugman (2012) suggest that a debt overhang may prevent further consumption in periods of high
indebtedness as households may be afraid or unable to increase borrowing levels because of binding
collateral constraints or a significant interest burden. Alpanda and Zubairy (2019) uses a similar local
projection approach to this paper in order to investigate the how household indebtedness levels affect
monetary policy transmission on GDP and consumption levels using data from the US between 1950-
2012. They find evidence that supports the theory that high household indebtedness or low net worth
weakens monetary policy transmission or the positive ‘household wealth channel’. They propose a
partial equilibrium model to shed light on the mechanism by which the ‘household wealth channel’
operates suggesting that households with close to binding collateral constraints are unable to benefit
immediately from a reduction in the policy rate and their average interest burden and instead are
forced to deleverage relative to less indebted households who respond immediately and strongest.
Under this result, when households are highly indebted, the paper suggests fiscal interventions may be
more suited to stimulating the economy. Even if households do not face collateral constraints, a

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precautionary savings motive for households in the face of low-equity mortgages, may dampen the
monetary policy transmission mechanism similarly to collateral constraints when households are
highly indebted (Mian & Sufi, 2014). Furthermore, Beraja et al. (2018) using micro level loan data in
the US, shows that households with low home equity cannot refinance even when mortgage rates fall.
Di Casola and Iversen (2019) using a Bayesian vector autoregression model on Swedish data, even
finds some evidence that in states with high household debt and low interest rates, monetary policy
shocks are neutral to inflation. Hence with such disparity between the two sides of this debate on the
effectiveness of monetary policy conditional on the state of household balance sheets, it is important
to explore these dynamics further.

3. Methodology

3.1. Identification of Monetary Policy Shocks

A well-known endogeneity problem that arises when looking to analyse the effect of monetary policy
on inflation, is the reverse causality between a monetary policy committee both reacting to and
influencing inflation levels with policy interventions. However, looking to obtain monetary policy
interventions that are orthogonal to the state of the economy in order to capture a valid response of
inflation to monetary policy, results in a trade-off where such orthogonal shocks tend to be small,
leading to issues of precision in the impulse responses generated from the local projections (LP)
approach. However in the search for consistent estimates of the impulse response function, in this
paper, I use the modern narrative approach introduced by Romer and Romer (2004) where monetary
policy shocks are generated through decomposing the change in interest rates into two components,

∆𝑖𝑡 = 𝑓(Ωt ) + 𝑒𝑡

where ∆𝑖𝑡 is the first difference of the policy rate at time t, 𝑓 is the unobservable central bank’s
reaction function to its information set Ωt at time t and 𝑒𝑡 is the residual which captures any
unexplained variation in the interest rate that isn’t as a result to the monetary policy authority’s
reaction to its information set. Hence 𝑒𝑡 is an estimate for the monetary policy shock at time t,
assuming that the wider economy operates with full information of the central bank’s reaction
function. In this paper, I assume the following reaction function adapted from Murgia (2020), where
𝜋̂𝑡+𝑖 describes the average of annual total HICP inflation point estimates of all ECB forecasters for the
year 𝑖 years ahead, 𝑦̂𝑡+𝑖𝑦 describes similar estimates for annual real GDP growth for the year 𝑖 years
ahead, 𝑢𝑡 describes the current unemployment rate across the Eurozone, 𝐴𝑡 describes the logarithm of
the total assets held by the ECB and 𝑖𝑡−2𝑤 describes the lagged interest rate level 2 weeks prior to
time 𝑡.

∆𝑖𝑡 = 𝛼 + 𝛽1 𝜋̂𝑡+1𝑦 + 𝛽2 𝜋̂𝑡+5𝑦 + 𝛽3 𝑦̂𝑡+1𝑦 + 𝛽4 𝑦̂𝑡+5𝑦 + 𝛽5 𝑢𝑡 + 𝛽6 𝐴𝑡 + 𝛽6 𝑖𝑡−2𝑤 + 𝑒𝑡

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The logarithm of the ECB total assets was included to control for any unconventional monetary
policies implemented, while unemployment levels are included in the regression to account for the
monetary policy authority’s considerations on labour markets. This regression was conducted using
quarterly forecast data from January 2000 to September 2023, sourced from the Survey of
Professional Forecasters (SPF) conducted by the ECB. I assume for ease that forecasts remain
constant for the quarter after they are published until the next publication allowing for monetary
policy shocks to be determined at a monthly frequency. The SPF dataset collects forecast data from
currently 145 professional economists from both the public and private sector and although there
exists some occasional divergence between the ECB staff macroeconomic projections, which are
published as a benchmark alongside the average of the SPF inflation rate point forecasts, there is still
significant correlation between these two forecasts, meaning that the SPF dataset provides a strong
proxy for the wider economy’s expectation on the ECB’s macroeconomic forecast upon which
monetary policy decisions are made.

The resulting series of monetary policy shocks 𝑒𝑡 are depicted in Figure 3, where there is significant
volatility in monetary policy shocks surrounding the 2008 Global Financial Crisis as expected.

Figure 3 – Monetary Policy Shocks generated (Source: Murgia (2020) and Author)

Using the modern narrative approach to monetary policy shock identification from Romer and Romer
(2004) is beneficial in this paper due to the lack of structure imposed by the identification method
relative to imposing sufficient sign restrictions. Furthermore, the Romer and Romer (2004) approach
allows for non-linearities in the form of dummy variables to be easily included in the second stage
regression which is central to the approach of this paper. However, the approach is not without its
drawbacks. Firstly, given the structural assumption imposed on the functional form and components
of the central bank’s reaction function it is still likely that issues of endogeneity between the estimated
shocks and inflation may still exist. Furthermore, we have assumed that the reaction function remains

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stable over time (Ramey, 2016), which is unlikely to be the case over different inflationary periods
each with different drivers of inflationary pressures. In further research, constructing a possibly
stronger instrument like that introduced by Miranda-Agrippino and Ricco (2021) that combines a
high-frequency identification approach with the Romer and Romer (2004) narrative approach whilst
incorporating features to account for lagged information absorption and the signalling effect of
monetary policy to the wider economy. A comparison between these estimation techniques shows that
Miranda-Agrippino and Ricco’s (2021) specification is unique in achieving exogeneity between leads
and lags of inflation whilst also satisfying the instrument relevance condition alongside the
specification outlined in by Romer and Romer (2004) (Ettmeier & Kriwoluzky, 2019).

3.2. Local Projections Estimation

To estimate the impulse response functions of inflation resulting from monetary policy shocks, I
leverage the local projections approach first introduced by Jorda (2005) and adapt it to allow for non-
linearities in the form of a dummy variable that describes the state of household balance sheets
according to a particular metric. To include the non-linearity I follow a similar regression
specification to Colavecchio and Rubene (2019) and include an interaction term between the
monetary policy shocks 𝑒𝑡 derived from the first stage regression and the state dummy 𝐷𝑡−1 . The
local projection uses HICP (Euro Area Harmonised Indices of Consumer Prices) and HICP core
inflation with a monthly frequency as dependent variables. To avoid issues of endogeneity the state
variable dummy has been included with a lag to minimise any contemporaneous correlation between
the monetary policy shocks and the state variable. Furthermore, to account for possible serial
dependence, I include lagged controls for real GDP growth. Finally when estimating the series of
linear regressions, I utilise the OLS estimator with the Newey-West correction (Newey & West, 1987)
to account for a heteroskedastic and autocorrelated error structure of lag ℎ months for each regression
within the local projection from ℎ ∈ [0,36].

𝜋𝑡+ℎ = 𝛼ℎ + 𝛽1,ℎ 𝑒𝑡 + 𝛽2,ℎ 𝑒𝑡 ∗ 𝐷𝑡−3𝑚 + 𝛽3 𝑦𝑡−1 + 𝑣𝑡

Using a local projection approach to compute the sensitivity of HICP inflation to monetary policy
shocks is advantageous relative to using structural vector-autoregression (VAR) models for several
reasons. Firstly, and most importantly for this paper, LPs provide significantly more flexibility in
implementing non-linearities within the model relative to Markov-switching or threshold VAR
models, which both require further structural assumptions to estimate and calibrate transition
probability functions between high and low states (Albuquerque, 2019). Furthermore, LPs are more
robust to model misspecifications as each horizon is computed independently as opposed to possibly
compounding errors through a VAR model (Plagborg-Møller & Wolf, 2021). However, LPs suffer
from less precise estimates at longer horizons than VAR models, however given their flexibility local
projections were best suited to this paper.

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3.3. Implementation of household balance sheet states
To create the binary variable 𝐷𝑡−1 included in the local projection specification above, I utilise two
different approaches to transform the linear data, sourced from the Quarterly Sector Accounts
collected at a quarterly frequency by the ECB. To include the quarterly data within the local
projections, which is run at a monthly frequency, I assume that the value assigned to each period for
each transformed metric of average household balance sheet is constant through each month of the
quarter. This is likely to be inconsequential to the analysis given that the binary states generated are
relatively persistent. Figure 4 outlines the different variables that describe the state of household
balance sheets used within this paper.

Variable
Deposits placed by households
Debt securities held by households
Total financial assets of households as a ratio of gross disposable income
Total financial assets of households
Loans granted to households
Loans granted to households as a ratio of GDP
Loans granted to households as a ratio of adjusted gross disposable income
Loans granted to households as a ratio of total financial assets
Total financial liabilities of households
Financial net worth of households
Net worth of households as a ratio of gross disposable income
Fixed assets by type of asset (net) of households
Household housing wealth
Adjusted gross disposable income of households
Gross saving of households
Net lending/borrowing of households

Figure 4 – Table of State Variables (Source: Quarterly Sector Accounts compiled by ECB)

The first approach leverages the Hodrick-Prescott (HP) filter in order to filter out the underlying trend
in each of the state variables, using a high smoothing parameter 𝜆 = 10,000, similar to that used in
Colavecchio & Rubene (2019), in order to ignore seasonal fluctuations within the dataset and only
consider larger more sustained fluctuations in household balance sheets within which monetary policy
shocks are transmitted. Using the HP filter, allows for non-constant trends in the 23-year observation
period, which should provide more accurate assignment of high or low states in the balance sheet
variable. Simply I then assign a 𝐷𝑡 = 1 if the variable is above the trend estimated by the HP filter
and 𝐷𝑡 = 0 otherwise, similar to the approach used in Harding and Klein (2022). However, given that
assigning binary states from a smoothed trend may result in slower state changes in the balance sheet

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metric being lost, I also employ a second approach of assigning binary state of 𝐷𝑡 = 1 dependent on
the variable being above its median level for the 23-year observation period.

Although transforming the balance sheet metrics into binary state variables result in the loss of much
of the nuances within these datasets as opposed to using a logit transformation to generate finer
intervals of the state of household balance sheets, binary variables allow for much simpler inference.
However, adapting the approach to include a limited dependent variable transformation to the state
variable could be used in further research.

Discussion of Results
Using the above methodology, we generate a series of impulse response functions using both the
binary HP filter and median filter transformations for all state variables as well as regressions on
aggregate HICP inflation and core HICP inflation. The impulse responses generated result from a 1
percentage point contractionary monetary policy shock. As previously mentioned, the identification
method used to construct the monetary policy shock series results in the shock series being
uncorrelated with any omitted variables in each regression hence the estimates for the impulse
responses at each horizon h are consistent. The impulse response functions are calculated over a 3-
year horizon and include 90% confidence intervals generated using the Newey-West correction for
standard errors and hence are robust in the presence of autocorrelation and heteroskedasticity. Lastly,
the impulse responses generated are symmetric given that positive and negative shocks are treated
equally in the estimation process and hence should apply in the case where there exists a 1 percentage
point expansionary monetary policy shock.

First let us analyse asset-related state variables by looking at the impulse responses associated with
total household assets (dhp_totalassets), debt securities issued by governments and financial
institutions and held by households (dhp_debtsecurities) and household saving levels (dhp_savings). I
include plots with and without confidence interval band for ease of interpretation. In each impulse
response plot, the red trace and band corresponds to the high state (𝐷𝑡−1 = 1) and the blue trace and
band correspond to the low state (𝐷𝑡−1 = 0). Figure 5 plots impulse response relating to total
household assets. The initial response of the economy in both states is positive and is much larger in
the state where nominal asset levels are low. The initial positive reaction of inflation in both cases can
be explained through businesses passing on immediate increases in financing costs from the
unexpected monetary policy shock to consumers who haven’t adjusted their consumption levels given
that lagged effects of monetary policy on aggregate demand (Blomhoff Holm, Paul, & Tischbirek,
2021). However, the final positive result inflation in the high household asset state to a contractionary
monetary policy shock goes against conventional theory and suggests the presence of the ‘price
puzzle’ within these estimates. This could be a result of the Romer and Romer identification strategy

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used for monetary policy shocks which is prone to such issues. Nevertheless the stronger negative
response to inflation to monetary tightening is low suggests that monetary policy is stronger in states
where relative debt is high and provides evidence for a potential ‘financial accelerator’ (Bernanke,
Gertler, & Gilchrist, 1999) and a negative ‘household wealth channel’.

Figure 5 - Impulse Response Functions for Total Household Asset State (Source: Author)

Figure 6 depicts the impulse response plots for household holding of government and private sector
debt securities, which illustrate a more conventional reaction from inflation to a contractionary policy
shock, with the initial inflationary pressure and final deflationary outcome. Debt securities holdings
provide a very direct link to household consumption behaviours with consumers initially benefit from
higher interest income following the contractionary shock but then substituting future consumption
with savings as the return of savings is higher. Although, the interest exposure is higher when debt
security holdings are high, this results in a negative ‘household wealth channel’. This result however
is in line with the Figure 5 as lesser holdings of debt securities relative to liabilities means household
net worth is low.

Figure 6 - Impulse Response Functions for Debt Securities held by households (Source: Author)

The states of gross household savings are explored in Figure 7, where high levels of savings (which
correspond to high household net worth) lead to lesser deflationary pressures. This negative
‘household wealth channel’ is common throughout all the asset-based state dependent local
projections. Furthermore, these results are supported by the equivalent specifications on core HICP
inflation as well as through the alternative transformation of the state variable utilising median
deviations.

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 Figure 7 - Impulse Response Functions for Household Savings Levels (Source: Author)

Moving on to the liabilities-based states, with Figures 8 and 9 depicting state variables for household
total liabilities and loan to income (LTI) levels. These provide evidence that contradicts the asset-
based state variables and supports a positive ‘household wealth channel’ where higher household net
worth or lower (relative) debt levels lead to higher deflationary pressures from contractionary policy
as highly indebted households experience a debt overhang meaning changes in consumption
behaviours are muted because of a high interest burden and collateral constraints. What is interesting
is that these impulse response series mirror each other closely suggesting that disposable income
levels have followed household liabilities closely.

Figure 8 - Impulse Response Functions for Household Total Liabilities (Source: Author)

Figure 9 - Impulse Response Functions for Household Loans to Gross Disposable Income (Source: Author)

Given that nominal borrowing stocks will follow house and asset price levels closely as debt remains
a relatively stable proportion of asset prices or income, with households withdrawing equity as assets
prices increase, it is possible that the results shown in Figures 8 and 9 don’t trace the finer fluctuations
in saving and borrowing behaviours of consumers which results in a misleading positive ‘household

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wealth channel’ being supported. Again, we see similar responses on core HICP inflation as well as
whilst utilising the median deviations transformation.

Lastly considering equity-based state variables, with Figures 10 and 11 depicting household net worth
and the net worth to gross disposable income ratio, we see continued evidence of a negative
‘household wealth channel’ of monetary policy. Interestingly though, like the total household asset
state variable we see the ‘price puzzle’ emerge for the state of high household net worth. Aside from
possible issues with the identification strategy of the monetary policy shock series, this may be caused
to a change in behaviour for households when in high asset or net worth states such that they benefit
from increased returns with higher rates. Given the higher asset base of households, an income effect
may be operating where although the savings have become relatively more attractive incentivizing
consumers to allocate more capital to savings, households maintain or even increase consumption
levels at the higher rate as they are able to maintain their target level of income with lesser savings.

Figure 10 - Impulse Response Functions for Household Net Worth (Source: Author)

Figure 11 - Impulse Response Functions for Household Net Worth to Gross Disposable Income (Source: Author)

Lastly considering housing equity as the state variable, we see a more conventional impulse response
plot in support of a negative ‘household wealth channel’. Overall when considering equity-based state
variables we see support for a positive wealth channel of monetary policy and again this supported by
the equivalent models for core inflation. However using the median deviations transformation,
housing wealth was significantly skewed by the extreme tails around the financial crisis and
pandemic.

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 Figure 12 - Impulse Response Functions for Household Housing Equity (Source: Author)

Hence, looking across different metrics within the household balance sheet we see some evidence in
support of a negative ‘household wealth channel’ resulting from increased exposure to debt and
interest burdens driving a ‘financial accelerator’ (Bernanke, Gertler, & Gilchrist, 1999). The results
above were significantly prone to the ‘price puzzle’, therefore in future research to combat this, the
identification strategy for the monetary policy shock series need to be amended.

The presence of a negative ‘household wealth effect’ does pose some implications for monetary policy
authorities to account for the state of household balance sheet when deciding the magnitude of policy
interventions. A key contemporaneous example of such a situation arose in the immediate post-
pandemic period where household wealth had shifted positively. Central banks in major economies
such as the UK, US and Euro area kept monetary policy incredibly loose, until aggregate demand
combined with significant post-pandemic supply chain disruptions led to strong inflationary pressures.
With evidence of a negative ‘household wealth channel’ of monetary policy dampening any potential
contractionary policy when household wealth is high, there could be an argument for these monetary
authorities to have intervened sooner and with greater magnitude given the diminished effectiveness
of their main policy tool. Hence, further empirical investigations are required to pin down the
direction and magnitude of the ‘household wealth channel’ of monetary policy, given the strong policy
implications for monetary authorities.

Conclusion
Using a non-linear local projection approach, this paper set out to explore the how the monetary
policy transmission mechanism for inflation targets differs with household balance sheets and as such
we have found some evidence of a negative ‘household wealth channel’ for monetary policy shocks.
This can be attributed to a possible ‘financial accelerator’ where expansionary policy fuels asset price
growth allowing highly indebted households react more strongly and withdraw housing equity further
increasing consumption and asset price growth (Bernanke, Gertler, & Gilchrist, 1999). The alternative
positive ‘household wealth effect’ hinged on highly indebted households being unable to respond to
expansionary policy interventions given that they significant interest burden and binding collateral
constraints. However, future research should look to remedy some of the empirical shortcomings of

14
the paper such the existence of the price puzzle within some impulse response functions, where
contractionary monetary policy leads to future inflationary pressures. Christiano, Eichenbaum and
Charles (1996) proposes to include commodity prices as an additional factor within the central bank’s
reaction function to control for the ‘prize puzzle’ and given the significant commodity price shock
within the data series resulting from the outbreak of the Russia-Ukraine war, this should corrected in
future research. Furthermore, using a nuanced tool such as a logit transformation as in Auerbach &
Gorodnichenko (2012) may uncover both negative and positive ‘household wealth channels’ operating
with a positive channel existing at extreme high levels of household debt close where there is a
significant interest burden, or collateral constraints present to overcome the negative channel that
dominates otherwise, similar to the NK model proposed by Alpanda and Zubairy (2019). Lastly,
improving the lead-lag exogeneity of the monetary policy shock instrument derived from Romer and
Romer (2004) using the hybrid approach proposed by Miranda-Agrippino & Ricco (2021) could
benefit the consistency of impulse response estimates generated. Despite these, this paper shows some
evidence of the negative ‘household wealth channel’ of monetary policy and encourages monetary
policy authorities to be wary about the effectiveness of these policy tools dependent on the state of
household balance sheets.

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