The Macroeconomic Effects of Housing Wealth, Housing Finance, and Limited Risk-Sharing in General Equilibrium

Abstract

We study a two-sector general equilibrium model of housing and non-housing production where heterogenous households face limited opportunities to insure against aggregate and idiosyncratic risks. The model generates large variability in the national house price-rent ratio, both because it fluctuates endogenously with the state of the economy and because it rises in response to a relaxation of credit constraints and decline in housing transaction costs (fi nancial market liberalization). These factors, together with a rise in foreign ownership of U.S. debt calibrated to match the actual increase over the period 2000-2006, generate an increase in the model price-rent ratio comparable to that observed in U.S. data over this period. The model also predicts a sharp decline in home prices starting in 2007, driven by the economic contraction and by a presumed reversal of the financial market liberalization. Fluctuations in the model's price-rent ratio are driven by changing risk premia, which fluctuate endogenously in response to cyclical shocks, the fi nancial market liberalization, and its subsequent reversal. By contrast, we show that the inflow of foreign money into domestic bond markets plays a small role in driving home prices, despite its large depressing influence on interest rates. Finally, the model implies that procyclical increases in equilibrium price-rent ratios reflect rational expectations of lower future housing returns, not higher future rents.