Error correction dynamics of house prices: An equilibrium benchmark

• Published in: Journal of housing economics Vol. 25; pp. 75 - 95
• Main Author: Leung, Charles Ka Yui
• Format: Journal Article
• Language: English
• Published: Elsevier Inc 01.09.2014
• Subjects: Central banks; Cointegration; Economic dynamics; Endogenous house price and income; Error correction models; Error-correction model; Fundamental house price; General economic equilibrium; House price-to-income ratio; Housing market; Housing prices; E30; Fundamental house price; House price-to-income ratio; Cointegration; Endogenous house price and income; Error-correction model; O40; R30
• ISSN: 1051-1377; 1096-0791
• DOI: 10.1016/j.jhe.2014.05.001

•The determination of the “fundamental house price” (FHP) is central to recent policy debate.•This paper builds a dynamic stochastic general equilibrium (DSGE) model.•It produces reduced-form dynamics that are consistent with previous error-correction models.•The dynamics of house prices are tied to the house-price-to-income ratio.•It justifies using the cointegration test between house prices and incomes to measure the FHP. Central to recent debates on the “mis-pricing” in the housing market and the proactive policy of central bank is the determination of the “fundamental house price.” This paper builds a dynamic stochastic general equilibrium (DSGE) model that produces reduced-form dynamics that are consistent with the error-correction models proposed by Malpezzi (1999) and Capozza et al. (2004). The dynamics of equilibrium house prices are tied to the dynamics of the house-price-to-income ratio. This paper also shows that house prices and incomes should be co-integrated, and hence provides a justification of using co-integration tests to detect possible “mis-pricing” in the housing market.