Welfare Effects of House Price Appreciation in the Economy with Binding Credit

Abstract

This research analyzes the effects of recent housing price appreciation on aggregate welfare. It generalizes the results of Bajari & Krainer (2005), who find that in the credit unconstrained economy with exogenous housing price there are no effects of housing price appreciation on aggregate welfare. However, I demonstrate that if households are credit constrained and house price is endogenous, itis appreciation implies non-zero change in aggregate welfare. First, credit constraints are incorporated into Bajariis model and it is shown that if they are binding, housing price appreciation implies improvement in aggregate welfare. Then I construct a model where house price appreciation is endogenous and is driven by demand and supply side shocks. The supply shock results from change in building permit cost. The demand shifts are generated based on dynamics of householdis income and interest rates. Both credit constrained and unconstrained versions of this model are considered. Afterwards using model implied house price elasticites the actual house price appreciation in US economy in 1995-2003 is decomposed into appreciation due to each of those shocks. Using this decomposition I calculate the model implied welfare adjustments for each of the shocks and for both credit constrained and unconstrained households and then sum up the resulting welfare adjustments over shocks and households. The final result implies that housing price appreciation in 1995-2003 led to the improvement of aggregate welfare per household by the amount equivalent to about 87% of median household income in 2003.