The work described in this proposal aims to build our understanding of the ways in which housing wealth and housing finance affect the macroeconomy and asset markets. Intellectual Merit: This proposal considers several specific questions of importance to both theoretical and empirical inquiry in financial economics. To what extent can episodes of national house price appreciation relative to housing fundamentals be attributed to a liberalization in housing finance, such as declines in collateral constraints or reductions in the costs of borrowing and conducting transactions? How do movements in house prices affect expectations about future housing fundamentals and future home price appreciation? To what extent do changes in housing wealth and housing finance affect output and investment, risk premia in housing and equity markets, measures of cross-sectional risk-sharing, life-cycle wealth-savings patterns, and the size of housing wealth e¤ects on consumer spending? The existing literature has addressed parts of these questions in isolation using either partial equilibrium models, or using general equilibrium models that abstract from some features of interest, such as idiosyncratic risk, output and production, or multiple risky asset markets. The goal of this research is to address these questions using a model that is sufficiently general as to account for the endogeneity of financial and housing wealth, real quantities, rates of return and risk premia, portfolio choice, and consumption and wealth inequality.The methodology is theoretical. The PI's study a two-sector general equilibrium model of housing and non-housing production where heterogenous households face limited risk-sharing opportunities as a result of incomplete financial markets for insuring both idiosyncratic and aggregate risks. A house in the model is a residential durable asset that provides utility to the household, is illiquid (expensive to trade), and can be used as collateral in debt obligations. The model economy is populated by a large number of overlapping generations of households who receive utility from both housing and nonhousing consumption and who face a stochastic life-cycle earnings profile. Broader Impact: The results of the proposed research will be of relevance to policymakers and market economists, as well as academics. Understanding the theoretical frameworks that can shed light on the endogenous relationships among wealth, consumption, asset markets and heterogeneity is fundamental for the informed and timely conduct of monetary policy, and for the effective use of macroeconomic analysis required of industry practitioners. In addition, the research described in this proposal, with its emphasis on the interplay between financial markets and the real economy, can also form a bedrock for studying the ramifications of specific policy initiatives, such as the likely effects of subsidizing housing transactions costs and interest payments and of more tightly regulating collateral requirements. The empirical investigations of this research agenda have the potential not only to expand the state of knowledge about the theoretical relationships between housing and the macroeconomy, but also to facilitate our understanding of the future course of economic activity, its implications for financial markets and house prices relative to housing fundamentals. In the wake of the global financial crisis that began in 2007, a better understanding of these mechanisms will be crucial to the continued implementation of sound economic policy and financial practice.
The main project findings may be briefly summarized as follows: ? House prices relative to measures of fundamental value are volatile, because they fluctuate procyclically and because they change in response to a financial market liberalization and influx of foreign capital into the bond market. ? A financial market liberalization drives price-rent ratios up, not because interest rates fall, but because it drives risk-premia down. ? A financial market liberalization leads to a short-run boom in consumption, but a short-run bust in investment. ? Financial market liberalization plus foreign capital leads to a shift in the composition of wealth towards housing for all age and income groups, increases financial wealth inequality, but has ambiguous affects on consumption inequality. ? Procyclical increases in equilibrium house price-rent ratios reflect lower future returns, not higher future rents. Intellectual merit and broader impacts: The results of the proposed research will be of relevance to policymakers and market economists, as well as academics. The theoretical investigation of this research agenda has the potential not only to expand our state of knowledge on the relationships among household balance sheets, collateral values, and international capital flows, but also to facilitate our understanding of the likely future course of economic activity, its implications for financial markets, and for house prices relative to housing fundamentals. In the wake of the global financial crisis that began in 2007, a better understanding of these mechanisms will be crucial to the implementation of sound economic policy and financial practice.
