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Can Learning Explain Boom-Bust Cycles In Asset Prices? An Application to the US Housing Boom

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  • Colin Caines

Abstract

Explaining asset price booms poses a difficult question for researchers in macroeconomics: how can large and persistent price growth be explained in the absence large and persistent variation in fundamentals? This paper argues that boom-bust behavior in asset prices can be explained by a model in which boundedly rational agents learn the process for prices. The key feature of the model is that learning operates in both the demand for assets and the supply of credit. Interactions between agents on either side of the market create complementarities in their respective beliefs, providing an additional source of propagation. In contrast, the paper shows why learning involving only one side on the market, which has been the focus of most of the literature, cannot plausibly explain persistent and large price booms. Quantitatively, the model explains recent experiences in US housing markets. A single unanticipated mortgage rate drop generates 20 quarters of price growth whilst capturing the full appreciation in US house prices in the early 2000s. The model is able to generate endogenous liberalizations in household lending conditions during price booms, consistent with US data, and replicates key volatilities of housing market variables at business cycle frequencies.

Suggested Citation

  • Colin Caines, 2016. "Can Learning Explain Boom-Bust Cycles In Asset Prices? An Application to the US Housing Boom," International Finance Discussion Papers 1181, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgif:1181
    DOI: 10.17016/IFDP.2016.1181
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    File URL: http://www.federalreserve.gov/econresdata/ifdp/2016/files/ifdp1181.pdf
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Colin Caines & Fabian Winkler, 2018. "Asset Price Learning and Optimal Monetary Policy," International Finance Discussion Papers 1236, Board of Governors of the Federal Reserve System (U.S.).
    2. Colin Caines & Fabian Winkler, 2019. "Asset Price Beliefs and Optimal Monetary Policy," 2019 Meeting Papers 713, Society for Economic Dynamics.
    3. Margaret Jacobson, 2019. "Beliefs, Aggregate Risk, and the U.S. Housing Boom," 2019 Meeting Papers 1549, Society for Economic Dynamics.

    More about this item

    Keywords

    Learning; Non-rational expectations; House prices; Boom-bust cycles;

    JEL classification:

    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • E17 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Forecasting and Simulation: Models and Applications
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • R30 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Real Estate Markets, Spatial Production Analysis, and Firm Location - - - General

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