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House prices, expectations, and time-varying fundamentals

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  • Paolo Gelain

    ()
    (Norges Bank (Central Bank of Norway))

  • Kevin J. Lansing

    ()
    (Federal Reserve Bank of San Francisco)

Abstract

We investigate the behavior of the equilibrium price-rent ratio for housing in a simple Lucas-type asset pricing model. We allow for time-varying risk aversion (via external habit formation) and time-varying persistence and volatility in the stochastic process for rent growth, consistent with U.S. data for the period 1960 to 2011. Under fully-rational expectations, the model signi ficantly underpredicts the volatility of the U.S. price-rent ratiofor reasonable levels of risk aversion. We demonstrate that the model can approximately match the volatility of the price-rent ratio in the data if near-rational agents continually update their estimates for the mean, persistence and volatility of fundamental rent growth using only recent data (i.e., the past 4 years), or if agents employ a simple moving-average forecast rule that places a large weight on the most recent observation. These two versions of the model can be distinguished by their predictions for the correlation between expected future returns on housing and the price-rent ratio. Only the moving-average model predicts a positive correlation such that agents tend to expect higher future returns when house prices are high relative to fundamentals–a feature that is consistent with survey evidence on the expectations of real-world housing investors.

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Bibliographic Info

Paper provided by Norges Bank in its series Working Paper with number 2013/05.

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Length: 40 pages
Date of creation: 04 Feb 2013
Date of revision:
Handle: RePEc:bno:worpap:2013_05

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Keywords: Asset pricing; Excess volatility; Housing bubbles; Predictability; Time-varying risk premiums; Expected returns;

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Citations

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Cited by:
  1. Beatrice D. Simo-Kengne & Stephen M. Miller & Rangan Gupta, 2013. "Evolution of Monetary Policy in the US: The Role of Asset Prices," Working Papers 201343, University of Pretoria, Department of Economics.
  2. John C. Williams, 2013. "Bubbles tomorrow and bubbles yesterday, but never bubbles today?," Speech 122, Federal Reserve Bank of San Francisco.
  3. Branch, William A. & Evans, George W., 2013. "Bubbles, crashes and risk," Economics Letters, Elsevier, vol. 120(2), pages 254-258.
  4. Gelain, Paolo & Lansing, Kevin J. & Mendicino, Caterina, 2012. "House Prices, Credit Growth, and Excess Volatility: Implications for Monetary and Macroprudential Policy," Dynare Working Papers 21, CEPREMAP.
  5. Tom Engsted & Thomas Q. Pedersen, 2013. "Housing market volatility in the OECD area: Evidence from VAR based return decompositions," CREATES Research Papers 2013-04, School of Economics and Management, University of Aarhus.

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