The economics of housing is a subject of increasing interest to economists as well as policy makers. For a typical household in the U.S., housing is not only the single most important consumption good but also the dominant component of wealth. Recent research has focused on the link between house price changes and consumption allocations. This literature, how ever, has been mostly empirical and cannot address the welfare consequences of house price changes for individual households.
When markets are complete, households can fully insure against their intertemporal consumption and income risks. House price changes will not have a significant impact on their consumption and welfare. In reality, however, lacking proper financial products to generate full risk-sharing, households are exposed to house price uncertainties. Owning a home can alleviate the problem by purchasing future housing services at today’s price. The hedging, however, is imperfect. Institutional and borrowing constraints frequently prevent young households with low levels of cash in hand from purchasing a house that matches their lifetime consumption need. Senior homeowners, in the meantime, are often forced to hold an equity position in their houses that lasts longer than their expected length of occupancy. This mismatch between life-cycle housing consumption need and housing investment position is worsened by the presence of lumpy adjustment costs in housing and mortgage markets.
In this paper, we investigate the effects of house price changes on household consumption and welfare, both at the aggregate level and over the life cycle. Using simulations under our parameterization, we show that although house price changes have limited net aggregate effects, their consumption and welfare consequences vary substantially at the individual household level and depend crucially on a household’s age and housing position. Specifically, the non-housing consumption of a young or old homeowner is more sensitive to house price changes than that of a middle-aged homeowner. More importantly, although house price appreciation increases the net worth and consumption of all homeowners, it only improves the welfare of old homeowners. Renters and young homeowners are worse off.
These results stem from two key features of the model: the households’ inability to insure against their lifetime income risks, and their inability to separate the dual role of housing as both a consumption good and an investment asset. A young homeowner is often liquidity-constrained because of his steep income profile and lack of access to credit. He is therefore more likely to take advantage of the relaxed collateral borrowing constraint afforded by house price appreciation and increase his non-housing consumption. An old homeowner has a short expected life horizon. Hence, he is more likely to capture the house wealth gains and increase his non-housing consumption accordingly. By contrast, a middle-aged homeowner has accumulated enough liquid savings to overcome the liquidity constraint and faces a relatively long expected life horizon. His consumption is thus least responsive to changes in house prices.
From the perspective of household welfare, house price appreciation does not lead to welfare improvement for all homeowners in our model simulation. Young homeowners expect to upgrade their housing services as their income and wealth increase. A positive house price shock, therefore, incurs net welfare losses for them, since the rise in the value of their existing homes is not large enough to compensate them for the rise in their lifetime housing costs. House price appreciation also lowers a renter’s lifetime welfare, since he suffers from higher costs in acquiring housing services and yet does not receive any housing wealth gains. Only old homeowners receive net welfare gains.
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