Liquidity Premia, Price-Rent Dynamics, and Business Cycles

n the U.S. economy during the past 25 years, house prices exhibit fluctuations considerably larger than house rents, and these large fluctuations tend to move together with business cycles. We build a simple theoretical model to characterize these observations by showing the tight connection between price-rent fluctuation and the liquidity constraint faced by productive firms. After developing economic intuition for this result, we estimate a medium-scale dynamic general equilibrium model to assess the empirical importance of the role the price-rent fluctuation plays in the business cycle. According to our estimation, a shock that drives most of the price-rent fluctuation explains 30 percent of output fluctuation over a six-year horizon.