The Macroeconomics and Financial Market Affectsof Housing Wealth and Housing Finance

New York University, New York NY

Investigators

Abstract

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.