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Endogenous UK Housing Cycles and the Risk Premium: Understanding the Next Housing Crisis

Author

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  • Geoffrey Meen

    () (Department of Economics, University of Reading)

  • Alexander Mihailov

    () (Department of Economics, University of Reading)

  • Yehui Wang

    () (Department of Economics, University of Reading)

Abstract

Despite the lessons of the post-2007 housing crisis, it would be dangerous to suggest that there will be no similar future events. Here we define a 'crisis' as a period of sustained worsening in affordability followed by a collapse in house prices, both of which were features of the 1996-2009 period. Extending the standard life-cycle housing approach to a three-asset model which incorporates interactions with financial markets and uncertainty, it can be shown that endogenous housing cycles can explain volatility. Three parameters drive the system - the income and price elasticities of housing demand and the degree of risk aversion. Furthermore, a key feature of UK housing policy over the last ten years or more has been an attempt to increase housing supply in order to stabilise affordability. The model demonstrates that stabilisation is impossible for any plausible level of construction, if affordability is measured by the ratio of house prices to incomes. Nevertheless, the market has built-in stabilisers; this is demonstrated through the use of stochastic simulations, which illustrate the dynamics of house prices implied by our expected utility model. The model derives explicitly a housing risk premium as a key determinant of the user cost and, hence, house prices and affordability, a factor commonly ignored in many housing models. Moreover, we find that exogenous, persistent 'ups and downs' similar to the Great Moderation - Global Financial Crisis period complement the endogenous propagation mechanism of our model.

Suggested Citation

  • Geoffrey Meen & Alexander Mihailov & Yehui Wang, 2016. "Endogenous UK Housing Cycles and the Risk Premium: Understanding the Next Housing Crisis," Economics & Management Discussion Papers em-dp2016-02, Henley Business School, Reading University.
  • Handle: RePEc:rdg:emxxdp:em-dp2016-02
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    File URL: http://www.reading.ac.uk/web/FILES/economics/emdp2016119.pdf
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    References listed on IDEAS

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    Cited by:

    1. Jinke Li & Geoffrey Meen, 2016. "Agent Based Models, Housing Fluctuations and the Role of Heterogeneous Expectations," Economics & Management Discussion Papers em-dp2016-09, Henley Business School, Reading University.

    More about this item

    Keywords

    house prices; life-cycle housing model; affordability; housing risk premium; endogenous housing cycles;

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • R21 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Household Analysis - - - Housing Demand
    • R31 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Real Estate Markets, Spatial Production Analysis, and Firm Location - - - Housing Supply and Markets
    • R38 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Real Estate Markets, Spatial Production Analysis, and Firm Location - - - Government Policy

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