Rising Earnings Instability, Portfolio Choice, and Housing Prices

Abstract

This paper studies the efiects of the U.S. rising earnings inequality between the late 1960s and the mid 1990s on the portfolio allocation and prices of assets. In order to investigate the link, a life-cycle general equilibrium model is constructed where distinct characteristics of the housing asset is explicitly modeled and asset prices are determined in equilibrium. It is shown that the model can produce a 9% rise in the housing price, which is about 40% of the changes in the U.S. data (24%). An increased demand for precautionary savings and the general equilibrium efiect play a crucial role here. A higher earnings volatility induces a higher demand for flnancial assets. As the return of flnancial assets declines due to the general equilibrium efiect, the demand for housing assets increases as well. The paper also examines the efiects of the rising earnings inequality on the aggregate amount of debt. Interestingly, contrary to the U.S. data, the model predicts a decline in the total amount of secured debt. A higher earnings volatility induces a higher amount of debt in complete markets models, but an increased demand for savings for precautionary motive dominates the positive efiect to the amount of debt. The model also shows that incorporating housing assets into the model does not make a signiflcant difierence in the efiect of the rising earnings inequality on the consumption inequality.