House prices, increasing returns, and the effects of government spending shocks

We report new regional evidence indicating that U.S. house prices increase persistently in the face of positive shocks to fiscal spending. In sharp contrast with this fact, though, house prices fall in conventional dynamic general equilibrium models where Ricardian households benefit from the flow of housing services. The inconsistency rests on the negative wealth effect exerted by the concurrent increase in the present-value tax burden, which increases the marginal utility of nondurable consumption, even in the presence of mechanisms that produce consumption crowding-in. As housing is a long-lived durable, shocks that do not exert a direct effect on its shadow value - such as those to fiscal spending - inevitably generate negative comovement between households' marginal utility of consumption and house prices. To address this problem, we devise a model combining endogenous entry in a monopolistically competitive sector producing nondurable intermediate goods with a certain degree of taste for variety. This generates increasing returns in aggregate production that induce total factor productivity to increase in the face of a fiscal expansion, thus overcoming the negative wealth effect. As a result, the response of Ricardian households' marginal utility of consumption flips sign, and so the response of house prices. The connection between house prices, business formation and productivity finds strong support in both regional and aggregate data.