What drives housing prices?

This paper develops a growth model with land, housing services, and other goods that is capable of explaining a substantial portion of the movements in housing prices over the past forty years. Under certainty, the model exhibits a balanced aggregate growth, but with underlying sectoral change. The paper introduces a Markov regime-switching specification for productivity growth in the nonhousing sector and shows that such regime switches are a plausible candidate for explaining - both qualitatively and quantitatively - the large low-frequency changes in housing price trends. In particular, the model shows how housing prices can have a \\"bubbly\\" appearance in which housing wealth rises faster than income for an extended period, then collapses and experiences an extended decline. The paper also uses micro data to calibrate a key cross-elasticity parameter that governs the relationship between productivity growth and home price appreciation. Combined with a realistic model of learning about the productivity process, the model is able to capture the medium- and low-frequency fluctuations of both price and quantity from the residential sector. Finally, the model suggests that the current downturn in the housing sector was triggered by a productivity slowdown that may have begun in 2004, an event that could reasonably have been viewed as highly unlikely by investors and mortgage issuers in the early part of the decade.