The Macroeconomic Effects of Housing Wealth, Housing Finance, andLimited Risk-Sharing in General Equilibrium

We study a two-sector general equilibrium model of housing andnon-housing production where heterogenous households face limitedopportunities to insure against aggregate and idiosyncratic risks. Themodel generates large variability in the national house price-rentratio, both because it fluctuates endogenously with the state of theeconomy and because it rises in response to a relaxation of creditconstraints and decline in housing transaction costs (fi nancial marketliberalization). These factors, together with a rise in foreignownership of U.S. debt calibrated to match the actual increase over theperiod 2000-2006, generate an increase in the model price-rent ratiocomparable to that observed in U.S. data over this period. The modelalso predicts a sharp decline in home prices starting in 2007, driven bythe economic contraction and by a presumed reversal of the financialmarket liberalization. Fluctuations in the model's price-rent ratio aredriven by changing risk premia, which fluctuate endogenously in responseto cyclical shocks, the fi nancial market liberalization, and itssubsequent reversal. By contrast, we show that the inflow of foreignmoney into domestic bond markets plays a small role in driving homeprices, despite its large depressing influence on interest rates.Finally, the model implies that procyclical increases in equilibriumprice-rent ratios reflect rational expectations of lower future housingreturns, not higher future rents.