Technology Shocks and Asset Price Dynamics: The Role of Housing in General Equilibrium

A general equilibrium model, that incorporates endogenous production and local housing markets, is developed in order to explain the price relationship among human capital, housing, and stocks, and to uncover the role of housing in asset pricing. Housing serves as an asset as well as a durable consumption good. It is shown that housing market conditions critically affect asset price correlations and risk premia. The first result is that the covariation of housing prices and stock prices can be negative if land supply is elastic. The second result is that housing rent growth serves as a risk factor in the pricing kernel. The risk premium becomes higher as land supply becomes inelastic and as housing services become more complementary to other goods. Data from OECD countries roughly support the model's predictions about the effects of land supply elasticity on asset price correlations, households' equity holdings, risk premium, and the price of risk. Finally, the housing component in the pricing kernel is shown to mitigate the equity premium puzzle and the risk-free rate puzzle.