I study the general equilibrium of the housing market in an economy populated by overlapping generations of households. A contribution of the present paper is to solve for the housing market equilibrium in the presence of aggregate (interest rate) uncertainty with a realistic mortgage contract. In addition, households also face idiosyncratic uncertainty resulting from stochastic changes over the lifecycle in tastes (or needs) for housing. In this environment, profit-maximizing banks offer fixed-rate mortgage (FRM) contracts to homebuyers. As seems plausible, each housing market transaction is subject to a fixed cost, which gives rise to S-s policy rules for housing transactions: existing homeowners change the size of their houses only if there is a sufficiently large change in the state of the economy (i.e., in interest rates, in their taste for housing, etc.). A plausibly calibrated version of the model is consistent with three empirically documented features of the housing market: (i) highly volatile housing prices and transaction volume, (ii) a strong positive correlation between transaction volume and housing prices, and (iii) a significant negative relationship between interest rates and housing prices, which can rationalize a large part of the recent boom in housing prices in the US and around the world.
I would like to thank Fatih Guvenen for his advice and encouragement. For helpful conversation and comments I thank, Arpad Abraham, Mark Aguiar, Mark Bils, Bulent Guler, William Hawkins, Jay H. Hong, Baris Kaymak, Onur Kesten, and Burhanettin Kuruscu as well as the seminar participants at University of Rochester, University of Texas at Austin, Sabanci University, TOBB University, Sveriges Riksbank, Federal Reserve Board and the Central Bank of the Republic of Turkey.
Appendix A: The effect of mortgage contract
As could be seen from Figure 15, interest rates have a very small effect on the transaction volume if the model does not have a mortgage contract. The housing price implications of a model without mortgage contracts are similar to those of model with mortgage contracts (Figure 16).
Appendix B: The effect of down payment requirements
Several papers used large down payment requirements to explain the comovement of transaction volume and housing prices. In Figure 17, I show that the existence of the down payments is not the driving force in the model.
Appendix C: First-order condition and market clearing errors
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