Housing Boom-Bust and Price-Rent Dynamics Over the Business Cycle

Abstract

Housing market is documented with several observations: considerably larger fluctuations in housing prices than in rents, correlation between housing prices and investment, lead-lag pattern of housing and macroeconomic variables. This paper constructs a two-sector housing model with home owning/renting heterogeneity and housing financial frictions to explain the observed facts in housing markets and to explore the interactions between housing markets, rental markets and mortgage markets. The model provides theoretical explanations to the housing boom-bust and the transmission mechanism of housing market fluctuations to business cycles. The paper predicts that house rent-price ratio correlates with expected house price growth and changes with temporary shocks in financial constraints and/or persistent changes in mortgage rates. Model extension suggests that home ownership is endogenously determined by down payment restrictions and aggregate shocks. The model matches with the empirical evidences observed in house market. The quantitative results suggest that the financial shock generates house price fluctuation considerably larger than rents, which explains the observed price-rent fluctuations.