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House prices, expectations, and time-varying fundamentals

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  • Paolo Gelain
  • Kevin J. Lansing

Abstract

We investigate the behavior of the equilibrium price-rent ratio for housing in a standard 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 significantly underpredicts the volatility of the U.S. price-rent ratio for 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 Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2013-03.

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Date of creation: 2013
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Handle: RePEc:fip:fedfwp:2013-03

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Keywords: Asset pricing ; Housing - Prices;

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References

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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. William A. Branch & George W. Evans, 2013. "Bubbles, Crashes and Risk," CDMA Working Paper Series 201306, Centre for Dynamic Macroeconomic Analysis.
  3. Paolo Gelain & Kevin J. Lansing & Caterina Mendicino, 2012. "House prices, credit growth, and excess volatility: Implications for monetary and macroprudential policy," Working Paper 2012/08, Norges Bank.
  4. 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.
  5. John C. Williams, 2013. "Bubbles tomorrow and bubbles yesterday, but never bubbles today?," Speech 122, Federal Reserve Bank of San Francisco.

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