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Housing Market Dynamics: On the Contribution of Income Shocks and Credit Constraints

(by Sven Rady, with François Ortalo-Magné)

Review of Economic Studies 73(2), April 2006, pp. 459-85

Earlier versions of this paper were circulated as:
CESifo Working Paper No. 470
LSE Financial Markets Group Discussion Paper No. 375
Munich Department of Economics Discussion Paper No. 01-09
CEPR Discussion Paper No. 3015
Munich Department of Economics Discussion Paper No. 2005-01 
SFB/Transregio 15 Discussion Paper No. 50

A first version of this material was circulated in 1998 under the title Housing Market Fluctuations in a Life-Cycle Economy with Credit Constraints.

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Abstract
We propose a life-cycle model of the housing market with a property ladder and a credit constraint. We focus on equilibria which replicate the facts that credit constraints delay some households' first home purchase and force other households to buy a home smaller than they would like. The model helps us identify a powerful driver of the housing market: the ability of young households to afford the down payment on a starter home, and in particular their income. The model also highlights a channel whereby changes in income may yield housing price overreaction, with prices of trade-up homes displaying the most volatility, and a positive correlation between housing prices and transactions. This channel relies on the capital gains or losses on starter homes incurred by credit-constrained owners. We provide empirical support for our arguments with evidence from both the U.K. and the U.S.

Keywords: Housing Demand, Income Fluctuations, Overlapping Generations, Collateral Constraint
JEL Classification: E32, G12, G21, R21

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