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Housing, house prices, and the equity premium puzzle

  • Morris A. Davis
  • Robert F. Martin

Many recent papers have claimed that when housing services are treated separately from other forms of consumption in utility, a wide range of economic puzzles such as the equity premium puzzle can be explained. Our paper challenges these claims. The key assumption embedded in this literature is that households are not very willing to substitute housing services for consumption. We show that housing services and consumption must be much more substitutable than has been assumed for a neoclassical consumption model to be consistent with U.S. house price data. Further, when forced to match both historical house prices and stock returns, the lowest risk-free rate the model can generate is 11 percent.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2005-13.

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Date of creation: 2005
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Handle: RePEc:fip:fedgfe:2005-13
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  1. Hall, Alastair R. & Inoue, Atsushi, 2003. "The large sample behaviour of the generalized method of moments estimator in misspecified models," Journal of Econometrics, Elsevier, vol. 114(2), pages 361-394, June.
  2. Raj Chetty & Adam Szeidl, 2004. "Consumption Commitments and Habit Formation," NBER Working Papers 10970, National Bureau of Economic Research, Inc.
  3. Peter Rupert & Richard Rogerson & Randall Wright, 1994. "Estimating substitution elasticities in household production models," Staff Report 186, Federal Reserve Bank of Minneapolis.
  4. Masao Ogaki & Carmen M. Reinhart, 1998. "Measuring Intertemporal Substitution: The Role of Durable Goods," Journal of Political Economy, University of Chicago Press, vol. 106(5), pages 1078-1098, October.
  5. West, Kenneth D., 2002. "Efficient GMM estimation of weak AR processes," Economics Letters, Elsevier, vol. 75(3), pages 415-418, May.
  6. Adam Szeidl & Raj Chetty, 2005. "Consumption Commitments: Neoclassical Foundations for Habit Formation," 2005 Meeting Papers 122, Society for Economic Dynamics.
  7. Joseph Gyourko & Joseph Tracy, 2003. "Using home maintenance and repairs to smooth variable earnings," Staff Reports 168, Federal Reserve Bank of New York.
  8. Joseph W. Gruber & Robert F. Martin, 2003. "Precautionary savings and the wealth distribution with illiquid durables," International Finance Discussion Papers 773, Board of Governors of the Federal Reserve System (U.S.).
  9. Davis, Morris & Heathcote, Jonathan, 2001. "Housing and the Business Cycle," Working Papers 01-09, Duke University, Department of Economics.
  10. George M. Constantinides, 2002. "Rational Asset Prices," NBER Working Papers 8826, National Bureau of Economic Research, Inc.
  11. Monika Piazzesi & Martin Schneider & Selale Tuzel, 2004. "Housing, Consumption and Asset Pricing," 2004 Meeting Papers 357c, Society for Economic Dynamics.
  12. Morris A. Davis & Jonathan Heathcote, 2004. "The price and quantity of residential land in the United States," Finance and Economics Discussion Series 2004-37, Board of Governors of the Federal Reserve System (U.S.).
  13. Fernández-Villaverde, Jesús & Krueger, Dirk, 2011. "Consumption And Saving Over The Life Cycle: How Important Are Consumer Durables?," Macroeconomic Dynamics, Cambridge University Press, vol. 15(05), pages 725-770, November.
  14. Andrews, Donald W K, 1991. "Heteroskedasticity and Autocorrelation Consistent Covariance Matrix Estimation," Econometrica, Econometric Society, vol. 59(3), pages 817-58, May.
  15. Hanno Lustig & Stijn Van Nieuwerburgh, 2004. "A Theory of Housing Collateral, Consumption Insurance and Risk Premia," NBER Working Papers 10955, National Bureau of Economic Research, Inc.
  16. Hanno Lustig & Stijn Van Nieuwerburgh, 2003. "Housing Collateral, Consumption Insurance and Risk Premia: An Empirical Perpective," NBER Working Papers 9959, National Bureau of Economic Research, Inc.
  17. Ellen R. McGrattan & Richard Rogerson & Randall Wright, 1995. "An equilibrium model of the business cycle with household production and fiscal policy," Staff Report 191, Federal Reserve Bank of Minneapolis.
  18. Robert F. Martin, 2003. "Consumption, durable goods, and transaction costs," International Finance Discussion Papers 756, Board of Governors of the Federal Reserve System (U.S.).
  19. Fratantoni, Michael C, 2001. "Homeownership, Committed Expenditure Risk, and the Stockholding Puzzle," Oxford Economic Papers, Oxford University Press, vol. 53(2), pages 241-59, April.
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