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Why Are Housing Prices So Volatile? Income Shocks in a Stochastic Heterogeneous-Agents Model

(by Sven Rady, with François Ortalo-Magné)

April 1999, last revised November 1999

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Abstract
Building on a stochastic life-cycle model with credit constraints and heterogeneous agents and dwellings, this paper clarifies the contribution of income fluctuations to housing price volatility. First, housing prices are shown to depend on the current income of young households. Empirical evidence from the UK and the US shows that this income variable is more volatile than aggregate income. Data also suggest that the income of young households affects housing prices independently of aggregate income. Second, credit market imperfections and the implied dependence of demand on recent capital gains amplify price fluctuations. This transmission mechanism is such that a mere slowdown of income growth may trigger a housing price downturn.

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