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This paper applies the Campbell-Shiller (1988) methodology to estimate a price dividend model with volatility and inflation risk, extending existing models in this field. The model fits the data well over the period 1979-2002 for the Euro Area, but less so for the U.S. The latter is interpreted as reflecting fads and is borne out by a decomposition of the price dividend ratio into a fundamental and bubble part. Finally, it is shown that deviations from fundamentals enter significantly in the Fed's interest rate reaction function but at the cost of destabilising monetary policy. Alternatively, in case that Fed policy remained stable, there was not much of attention to asset bubbles. For the Euro Area, historically, the reaction function does not appear to react much to asset prices.

Cover -- Contents -- I. Introduction -- II. The Role Of Debt in Macro-Financial Models -- III. Empirical Analysis and Results -- A. Household Debt and Output Growth in 80 Countries -- B. Institutional Factors and Distributional Characteristics -- C. Systemic Banking Crises -- D. Neglected Downside Risk -- E. Debt Overhang: Micro-Level Evidence -- IV. Robustness: Panel Var Analysis -- A. Exchange Rate Regime -- B. Distributional Characteristics of Household Debt -- V. Conclusions -- Appendix I. Data Description and Methodology -- Appendix II. Tables and Figures -- A. Tables -- B. Figures -- References -- Tables -- 1. Summary Statistics -- 2a. Household Debt and Future GDP Growth -- 2b. Household Debt and Future GDP Growth: AEs and EMs -- 3. The Role of Institutional Factors, Policies, and Household-Level Debt Characteristics -- 4. Probability of Systemic Banking Crisis -- 5a. Probability of Systemic Banking Crisis: Robustness-Lags -- 5b. Probability of Systemic Banking Crisis: Robustness-Methods -- 6. Bank Equity Returns and Crashes -- 7. Abnormal Returns for Bank Stocks -- 8. Euro Area: Household Debt Overhang -- Figures -- 1. Systemic Banking Crises: Area Under Curve (AUC) -- 2. Europe: Debt Overhang and Consumption (Macro-Level) -- 3. Euro Area Households: Debt Overhang and Consumption (Micro-Level) -- 4. Panel Var Analysis: Baseline -- 5. Panel Var Analysis: High vs Low Exchange Rate Flexibility -- 6. Panel Var Analysis: Participation Rate of Low-Income Households and Financial Development -- 7. Panel Var Analysis: High vs Low Participation for Low Income Borrowers -- 8. Panel Var Analysis: High vs Low Debt Share for Low-Income Borrowers.