Housing Cycle and Interet Rate

Abstract

The most recent boom-bust episode in the housing market and its unprecedented negative repercussions on the overall economy led to a debate on its possible causes. The common assumption underlying the debate is that interest rates were the main driver of the bubble in house prices. However the empirical literature provides merely inconclusive evidence on the dominant role of interest rates in house price dynamism. Based on a comprehensive review of the existing literature combined with the author's own reasoning and observation, a hypothesis is elicited that not only interest rates but also expectation play major roles in rendering house prices more volatile than otherwise. To check for the validity of it, a different regression strategy from common empirical models is adopted employing the volatile components of house prices as a dependent variable instead of house prices themselves. The empirical results using the U.S. data are consistent with the hypothesis confirming the primacy of interest rates in generating house price fluctuations and the importance of expectation channel transmitting the effects of interest rates.