Market Fundamentals, Rational Expectation and Housing Price Changes: Evidence from Housing Market in Beijing

Abstract

Do market fundamentals explain house price inflation in Beijing? This paper answers the above by estimating the current value of residential houses in Beijing as the conditional expectations of the discounted stream of housing services accruing to the owner of houses. The value of housing services is represented by the imputed rent that is estimated by three market fundamentals – urban disposable income, the number of population and housing vacancy area. The cross-equation restrictions are tested between the restricted reduced form of the model under the assumption of rational expectation, and the unrestricted model governing the stochastic process of imputed rents. Empirical tests reject the null hypothesis of rational expectation. The cross-equation restrictions are not valid within the two tested models. The unrestricted model explains 60% of the changes in housing prices, and the residuals suggest that the model generally underestimated the extent of housing price changes that actually took place during periods of boom.