House prices, expectations, and time-varying fundamentals

Paolo Gelain and Kevin Lansing

No 2013/05, Working Paper from Norges Bank

Abstract: We investigate the behavior of the equilibrium price-rent ratio for housing in a simple Lucas-type asset pricing model. We allow for time-varying risk aversion (via external habit formation) and time-varying persistence and volatility in the stochastic process for rent growth, consistent with U.S. data for the period 1960 to 2011. Under fully-rational expectations, the model signi ficantly underpredicts the volatility of the U.S. price-rent ratiofor reasonable levels of risk aversion. We demonstrate that the model can approximately match the volatility of the price-rent ratio in the data if near-rational agents continually update their estimates for the mean, persistence and volatility of fundamental rent growth using only recent data (i.e., the past 4 years), or if agents employ a simple moving-average forecast rule that places a large weight on the most recent observation. These two versions of the model can be distinguished by their predictions for the correlation between expected future returns on housing and the price-rent ratio. Only the moving-average model predicts a positive correlation such that agents tend to expect higher future returns when house prices are high relative to fundamentals–a feature that is consistent with survey evidence on the expectations of real-world housing investors.

Keywords: Asset pricing; Excess volatility; Housing bubbles; Predictability; Time-varying risk premiums; Expected returns (search for similar items in EconPapers)
JEL-codes: D84 E32 E44 G12 O40 R31 (search for similar items in EconPapers)
Pages: 40 pages
Date: 2013-02-04
New Economics Papers: this item is included in nep-dge and nep-ure
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Citations: View citations in EconPapers (14)

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https://www.norges-bank.no/en/news-events/news-pub ... pers/2013/WP-201305/

Related works:
Journal Article: House prices, expectations, and time-varying fundamentals (2014)
Working Paper: House Prices, Expectations, and Time-Varying Fundamentals (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:bno:worpap:2013_05

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