Summer 2011Summer 2011

Macroeconomics – Lecture 1Extra Slides

Macroeconomics – Lecture 1Extra Slides

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Understanding Housing Prices

Average Annual Real Housing Price Growth By US State

State 1980-2000 2000-2007 State 1980-2000 2000-2007AK -0.001 0.041 MT 0.003 0.049AL 0.000 0.024 NC 0.008 0.022AR -0.009 0.023 ND -0.010 0.033AZ -0.002 0.061 NE -0.002 0.007CA 0.012 0.066 NH 0.014 0.041CO 0.012 0.012 NJ 0.015 0.058CT 0.012 0.044 NM -0.002 0.043DC 0.010 0.081 NV -0.005 0.060DE 0.011 0.053 NY 0.020 0.051FL -0.002 0.068 OH 0.003 -0.001GA 0.008 0.019 OK -0.019 0.019HI 0.004 0.074 OR 0.009 0.051IA -0.001 0.012 PA 0.008 0.042ID -0.001 0.047 RI 0.017 0.059IL 0.010 0.030 SC 0.007 0.025IN 0.002 0.020 SD 0.002 0.025

Average 0.011 0.0363

Typical “Local” Cycle

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Typical “Local” Cycle

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Housing Prices and Housing Cycles (Hurst and Guerrieri (2009))

• Persistent housing price increases are ALWAYS followed by persistent housing price declines

Some statistics about U.S. metropolitan areas 1980 – 2000

• 44 MSAs had price appreciations of at least 15% over 3 years during this period.

• Average price increase over boom (consecutive periods of price increases): 55%

• Average price decline during bust (the following period of price declines): 30%

• Average length of bust: 26 quarters (i.e., 7 years)

• 40% of the price decline occurred in first 2 years of bust 7

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AKAL

AR

AZ

CA

CO

CT

DCDE

FL

GAHI

IAID

ILIN

KSKY

LA

MAMD

ME

MI

MN

MOMS

MTNC

ND

NE

NHNJ

NM

NV

NY

OH

OK

ORPA

RI

SCSD

TN

TXUT

VA

VTWA

WI

WV

-.8

-.6

-.4

-.2

0

0 .5 1g_97_05

g_05_09 Fitted values

Real House Price Changes By State: 1997-2005 (x-axis) vs. 2005 – 2009 (y-axis)

Typical “Country” Cycle (US – OFHEO Data)

U.S. Nominal House Price Appreciation: 1976 - 2008

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Typical “Country” Cycle (US – OFHEO Data)

U.S. Real House Price Appreciation: 1976 - 2008

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Country 1970-1999 2000-2006 Country 1970-1999 2000-2006

U.S. 0.012 0.055 Netherlands 0.023 0.027Japan 0.010 -0.045 Belgium 0.019 0.064

Germany 0.001 -0.029 Sweden -0.002 0.059France 0.010 0.075 Switzerland 0.000 0.019

Great Britain 0.022 0.068 Denmark 0.011 0.065Italy 0.012 0.051 Norway 0.012 0.047

Canada 0.013 0.060 Finland 0.009 0.040Spain 0.019 0.081 New Zealand 0.014 0.080

Australia 0.015 0.065 Ireland 0.022 0.059

Average 1970-1999 0.0122000-2006 0.046

Average Annual Real Price Growth By OECD Country

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Country Cycles – The U.S. is Not Alone

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Country Cycles – The U.S. is Not Alone

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Country Cycles – The U.S. is Not Alone

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Regression Analysis

• Use Historical Analysis (Country, State, Metropolitan Area)

• Regress Size of Subsequent Bust on Size of Consecutive Boom

• Depending on the sample, coefficient on mean revision ranged from: -0.5 to -0.6.

• Implication: 100% increase in house prices are usually followed by periods of 50% - 60% declines.

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Equilibrium in Housing Markets

Demand

PH

QH

Fixed Supply (Short Run)

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Equilibrium in Housing Markets

Demand

PH

QH

Fixed Supply (Short Run)

PH’

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Equilibrium in Housing Markets

Demand

PH

QH

Fixed Supply (Short Run)

PH’

Demand shocks cause large price increases when supply is fixed

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Equilibrium in Housing Markets

Demand

PH

QH

Fixed Supply

PH’Supply Eventually Adjusts

PH”

How Does Supply Adjust?

• Build on Vacant Land

• Convert Rental or Commercial Property

• Build Up

• Build Out (Suburbs)

• Build Way Out (Create New Cities)

• Some of these adjustments can take consider amounts of time.

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Do Supply Factors Explain 2000-2008 Cycle

Change in Total Housing Units Against Change in Housing Price

Adjusted for Population Changes (2000-2005, State Level)

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AK

AL

AR

AZ CA

CO

CTDC

DEFL

GA

HI

IA

ID

IL

IN

KSKY

LA

MA

MD

ME

MI

MN

MO

MS

MT

NC

ND

NE

NHNJ

NM

NV

NY

OH

OK

OR

PA

RI

SC SD

TN

TX

UT

VA

VTWA

WI

WVWY

-.04

-.02

0.0

2.0

4

-.2 0 .2 .4 .6Residuals

Residuals Fitted values

Do Supply Factors Explain 2000-2008 Cycle

Change in Total Housing Units Against Change in Housing Price

Adjusted for Population Changes (2005-2009, State Level)

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AK

AL

AR

AZ

CACO

CT

DC

DE

FL

GA

HI

IA

ID

IL

INKS

KY

LA

MA

MD

MEMI

MN

MO

MS

MT

NC

ND

NE

NH

NJ

NM

NV

NY

OH

OKORPA

RISC

SDTN

TX

UT

VA VTWA

WIWV

WY

-.03

-.02

-.01

0.0

1.0

2

-.6 -.4 -.2 0 .2Residuals

Residuals Fitted values

Country 1970-1999 2000-2006 Country 1970-1999 2000-2006

U.S. 0.012 0.055 Netherlands 0.023 0.027Japan 0.010 -0.045 Belgium 0.019 0.064

Germany 0.001 -0.029 Sweden -0.002 0.059France 0.010 0.075 Switzerland 0.000 0.019

Great Britain 0.022 0.068 Denmark 0.011 0.065Italy 0.012 0.051 Norway 0.012 0.047

Canada 0.013 0.060 Finland 0.009 0.040Spain 0.019 0.081 New Zealand 0.014 0.080

Australia 0.015 0.065 Ireland 0.022 0.059

Average 1970-1999 0.0122000-2006 0.046

Average Annual Real Price Growth By OECD Country

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What Does This All Mean

• Decline in Residential Housing Prices in the U.S. was very predictable (although the timing was not).

• Using OFHEO price index, real housing prices rose by 46% between 1997 and 2006 (for the entire U.S.).

• My model predicts that housing prices will fall by roughly 25-30% (in real terms) over the next 5-7 years.

• So far, the real OFHEO price index has fallen by roughly 15-20% (from peak to current levels).

• More “real” residential price declines to come! (Nominal prices should stabilize late this year/early next year).

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U.S. OFHEO Housing Cycle - Levels

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Bonus Material: The Yield Curve

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What is a Yield Curve

• A yield curve graphs the interest rate for a given security of differing maturities.• For example, it represents the yield on 1, 3, 5, 7, and 10 year treasuries.

Historically, yield curves tend to be upward slopingData on U.S. treasury yields from late 2004

Maturity (in years)

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Yield Curve Mechanics

• Consider a two period model

• Define the interest rate on a one year treasury starting today as i0,1

• Define the interest rate on a two year treasury starting today as i0,2

• What is the relationship between one year treasuries and two year treasuries?

• Appeal to theory of arbitrage. If arbitrage holds, then by definition:

(1 + i0,2)2 = (1 + i0,1) * (1 + i1,2)

where i1,2 is the interest rate on a one year treasury starting one period from now.

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Shape of the Yield Curve: Macro Explanations

• Solve for long interest rates (i0,2) as a function of short rates:

i0,2 = [(1+i0,1) * (1+i1,2)]1/2 – 1

• Question: When does the yield curve slope up (i.e., i0,2 > i0,1)?

• Answer: When i1,2 > i0,1

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Shape of the Yield Curve: Macro Explanations

• When does i1,2 > i0,1 ?

• Remember: i = r + πe + ρ (or, with time subscripts, i0,1 = r0,1 + πe0,1 + ρ0,1)

where ρ is a risk premium

• To start, assume risk free assets (ρ = 0)

• So, if r is held fixed over time (i.e., r0,1 = r1,2) then the yield curve will slope up if πe

1,2 > πe0,1. Increasing inflation will cause the yield curve to slope up (all else

equal)!

• Also, if πe is fixed over time (i.e., πe

1,2 = πe0,1) then the yield curve will slope up if

r1,2 > r0,1. Higher future real rates will cause the yield curve to slope up (all else equal).

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Shape of the Yield Curve: Micro Explanations

• Suppose ρ is not equal to zero such that:

i = r + π + ρ

• Alluding back to our previous discussion, i1,2 > i0,1 if ρ1,2 > ρ0,1

• Components of ρ include default premiums and term premiums

• Changes in ρ for long term assets relative to short term assets (i.e., a decline in the term premium) will affect shape of the yield curve.

• See an interesting discussion by Ben Bernanke on the shape of yield curves:http://www.federalreserve.gov/boarddocs/Speeches/2006/20060320/default.htm

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Flat or Inverted Yield Curves

• There is no reason that yield curves need to slope upwards. Expected future short term rates could be the same or lower than current short term rates. This would imply that current long rates will be the same or lower than current short rates.

• This will lead to flat yield curves (current short rates = current long rates) or inverted yield curves (current short rates > current long rates).

• This possibility could exist in equilibrium! This will occur if inflation is expected to decline over time (or if deflation is predicted), if future expectations of real interest rates are lower than current real interest rates, and if risk premiums in the future are thought to decline.

• Key: Some people assume that a flat or inverted yield curve means that the economy will be entering a recession! This is not always true. But, demand side recessions cause both r and expected inflation to fall.

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Current Yield Curve for U.S. Treasuries (12/1/09)

0

0.5

1

1.5

2

2.5

3

3.5

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Other Flattening of the Yield Curve: Micro Explanations

• One component of the term premium: Uncertainty in the future

– If investors are risk averse and the government is risk neutral, an equilibrium could exist where the government will compensate borrowers for holding longer term assets.

– A decline in uncertainty (perhaps due to the “Great Moderation”) could flatten yield curves relative to historical standards.

• A second component of the term premium: Liquidity premium

– If short term assets are more liquid than long term assets (or demand for short term assets is relatively higher than long term assets), a risk premium will exist.

– An increase in the demand for long term U.S. assets (perhaps by foreign investors) could cause the yield curve to flatten.

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Current “10”- “2” Year Treasury (Through 2/09)