Skip to content
Licensed Unlicensed Requires Authentication Published by De Gruyter February 14, 2014

Interest rate fluctuations and equilibrium in the housing market

  • Yavuz Arslan EMAIL logo


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.

Corresponding author: Yavuz Arslan, The Central Bank of the Republic of Turkey, Istiklal Cad., No: 10, Ulus/Ankara, 06100, Turkey, Phone: (90) 312 5075476, e-mail:


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).

Figure 15 Transaction volume without mortgage contracts.
Figure 15

Transaction volume without mortgage contracts.

Figure 16 Housing prices without mortgage contracts.
Figure 16

Housing prices without mortgage contracts.

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.

Figure 17 Comovement of transaction volume and housing prices. No down payment
Figure 17

Comovement of transaction volume and housing prices. No down payment

Appendix C: First-order condition and market clearing errors


Berkovec, J., and J. Goodman. 1996. “Turnover as a Measure of Demand for Existing Homes.” Real Estate Economics 24: 421–440.10.1111/1540-6229.00698Search in Google Scholar

Campbell, J., and J. F. Cocco. 2003. “Household Risk Management and Optimal Mortgage Choice.” Quarterly Journal of Economics 118 (4): 1449–1494.10.1162/003355303322552847Search in Google Scholar

Genesove, D., and C. Mayer. 2001. “Loss Aversion and Seller Behavior: Evidence from Housing Market.” Quarterly Journal of Economics 116 (4): 1233–1260.10.1162/003355301753265561Search in Google Scholar

Hanushek, E. A., and J. M. Quigley. 1980. “What is the Price Elasticity of Housing Demand.” The Review of Economics and Statistics 62 (3): 449–454.10.2307/1927113Search in Google Scholar

Heathcote, J., and M. Davis. 2005. “Housing and the Business Cycle.” International Economic Review 46 (3): 751–784.10.1111/j.1468-2354.2005.00345.xSearch in Google Scholar

Himmelberg, C., C. Mayer, and T. Sinai. 2005. “Assesing High House Prices: Bubbles, Fundamentals, and Misperceptions.” Journal of Economic Perspectives 19: 67–92.10.1257/089533005775196769Search in Google Scholar

Hurst, Erik, Ming Ching Luoh, Frank P. Stafford, and William G. Gale. 1998. “The Wealth Dynamics of American Families, 1984–1994.” Brookings Papers on Economic Activity 1998 29 (1): 267–337.10.2307/2534673Search in Google Scholar

Hussey, R., and G. Tauchen. 1992. “Quadrature-Based Methods For Obtaining Approximate Solutions for Nonlinear Asset Pricing Models.” Econometrica 59: 371–396.Search in Google Scholar

Iacoviello, M. 2005. “House Prices, Borrowing Constraints, and Monetary Policy in the Business Cycle.” American Economic Review 95 (3): 739–764.10.1257/0002828054201477Search in Google Scholar

Iacoviello, Matteo, and Stefano Neri. 2010. “Housing Market Spillovers: Evidence from an Estimated DSGE Model.” American Economic Journal: Macroeconomics 2 (April): 125–164.10.1257/mac.2.2.125Search in Google Scholar

Krusell, P., and A. Smith. 1998. “Income and Wealth Heterogeneity in the Macroeconomy.” Journal of Political Economy 106 (5): 867–896.10.1086/250034Search in Google Scholar

Lucas, R. 1978. “Asset Prices in an Exchange Economy.” Econometrica 46: 1426–1445.10.2307/1913837Search in Google Scholar

Lucas, R., E., Jr. 1987. Models of Business Cycles. New York, Blackwell.Search in Google Scholar

Lustig, H., and Yi-Li Chien. 2010. “The Market Price of Aggregate Risk and the Wealth Distribution.” Review of Financial Studies 23 (4): 1596–1650.10.1093/rfs/hhp079Search in Google Scholar

Ortalo-Magne, R., and S. Rady. 1999. “Boom In, Bust Out: Young Households and the Housing Price Cycle.” European Economic Review 43: 755–766.10.1016/S0014-2921(98)00091-9Search in Google Scholar

Rios-Rull, J., and V. Sanchez-Marcos. 2008. “An Aggregate Economy with Different Size Houses.” Journal of the European Economic Association 6 (2–3): 705–714.10.1162/JEEA.2008.6.2-3.705Search in Google Scholar

Stein, C. J. 1995. “Prices and Trading Volume in the Housing Market: A Model with Down-Payment Effects.” The Quarterly Journal of Economics 110 (2): 379–406.10.2307/2118444Search in Google Scholar

Veracierto, Marcelo. 2002. “Plant Level Irreversible Investment and Equilibrium Business Cycles.” American Economic Review 92: 181–197.10.1257/000282802760015667Search in Google Scholar

Veracierto, Marcelo. 2008. “Firing Costs and Business Cycle Fluctuations.” International Economic Review 49 (1): 1–39.10.1111/j.1468-2354.2008.00472.xSearch in Google Scholar

Wheaton, W. 1990. “Vacancy, Search, and Prices in a Housing Market Matching Model.” Journal of Political Economy 98: 1270–1292.10.1086/261734Search in Google Scholar

Published Online: 2014-2-14
Published in Print: 2014-1-1

©2014 by De Gruyter

Downloaded on 27.3.2023 from
Scroll Up Arrow