A dynamic equilibrium between house price interest payments and income

The literature on housing markets suggests that house prices in almost all western economies can be explained only by demand-oriented variables. Particular attention is devoted to the speculative or psychological effects. When prices continue to increase, consumers speculate on further rises and act swiftly. Models have been compiled of these short-run price fluctuations, or ëshocksí, based on recent price developments. The terms ëbubble builderí and ëbubble bursterí are often used in this context. However, other more permanent factors play a role in the development of house prices. Many analytical models include income, inflation and mortgage interest payments as explanatory variables for house price trends. To ensure that long-term price developments can be explained by permanent factors, these models incorporate the deviation from price equilibrium, with the permanent characteristics as the corrective variable (error-correction models). This ëlong-run equilibriumí is usually expressed as a price-to-income ratio. This paper seeks to identify a long-run equilibrium between mortgage interest payments and household income in the Netherlands. We consider both a static equilibrium and a dynamic equilibrium. We conclude that interest payments do appear to be linked to income levels.