House Price Dynamics : Fundamentals and Expectations

We investigate whether expectations that are not fully rational have the potential to explain the evolution of house prices and the price-to-rent ratio in the United States. First, a stylized asset-pricing model solved under rational expectations is used to derive a fundamental value for house prices and the price-rent ratio. Although the model can explain the sample average of the price-rent ratio, it does not generate the large and persistent fluctuations observed in the data. Then, we consider a rational bubble solution and two extrapolative expectations solutions: one that features a constant extrapolation parameter and one in which the extrapolation coefficient is an increasing function of the deviation of the growth rate of rents from its mean. In this last solution the degree of extrapolation is stronger in good times than in bad times, generating waves of over-optimism. We show that under this solution the model not only is able to match key moments of the data but can also replicate the run up in the U.S. house prices observed over the 2000-2006 period and the subsequent sharp downturn