Life-cycle theory, inflation, and the demand for housing

Abstract

There has been considerable interest lately in the influence of economywide inflation on the demand for housing. Under suitable equilibrium conditions, such inflation creates three effects, each of which may influence housing decisions. First, inflation raises initial mortgage payments through higher interest rates. Second, it causes such payments to fall rapidly over time in real terms, and third, it creates a real growth in housing equity, as borrowed debt is leveraged against the inflating value of homes. Two empirical studies, one by Kearl [6], and more recently by Follain [3], have concluded that the sum of these impacts is adverse, that is, housing demand is reduced by greater economy-wide inflation. Each suggests that credit constraints may explain this result. In an attempt to understand better the microeconomic foundations of this empirical result, Schwab [9], and Dougherty and Van Order [2] have developed Fisher-type models of intertemporal utility maximization, which include a housing consumption choice. Schwab concludes that with a perfect capital market, inflation should induce no distortion in consumer decisions about housing consumption. Dougherty and Van Order, building on some unpublished work by Poterba [8], argue that with interest deductibility from income taxes, inflation reduces the “after tax cost of housing capital,” and thereby increases housing demand. These conclusions suggest that capital market imperfection must exist, to explain the empirical results, but just what kind? Schwab’s paper addresses this question by introducing a borrowing constraint into a two-period model [9]. The constraint is absolute, although Schwab acknowledges that allowing collateralized borrowing is more realistic. Schwab’s conclusions are two. First, he argues that if the constraint is nonbinding then the perfect capital market results prevail, and second, he demonstrates that if the constraints are binding, the effect of inflation on