How Does Consumption Spending Respond to Housing Prices?

Many factors can influence the value of a house. Homeowners tear down walls and install new appliances to increase the value of their houses. Larger forces, like natural disasters or local economic development, can also have an impact on a home’s potential price on the market. Changing home valuations can also affect the consumption of the people who live there.

Home prices affect consumption in two ways. First, if the value of a house increases, this may encourage homeowners to increase consumption because they believe that their wealth has increased. Second, homeowners may be more willing to borrow because the house can be used as collateral, reducing credit constraints. In the context of economic cycles, the relationship between housing prices and household spending has policy implications for a country’s financial stability and monetary policy. In particular, a large fall in housing prices could explain some of the observed decline in consumption during recessions.

In a new study, David Berger, Veronica Guerrieri, Guido Lorenzoni, and Joseph Vavra model how consumption responds to changes in housing prices. The authors develop a new theoretical approach to explain the high average elasticity, or responsiveness, of consumption to house prices. The reasoning behind this approach is that, when there is a long-term change in house prices, resulting changes in consumption can be approximated using homeowners’ marginal propensity to consume and their home values.

The authors use the Panel Study of Income Dynamics (PSID) to gather information on income, consumption, and housing values. This study began in 1968 with a nationally representative sample of over 5,000 American households and tracks these families every other year, along with their “split-offs” (children who form families of their own).

Using a subset of PSID data from 1999 onward, the authors determine that consumption elasticity has a “humped” shape with regard to age and housing prices. This means that spending habits for middle-aged individuals are very responsive to changes in home prices, while the very old and the young have more constant consumption rates. The authors believe this happens because middle-aged individuals have the greatest rates of homeownership and consumption, relative to other groups. Specifically, the peak rates of homeownership and marginal propensity to consume coincide with the 45-64 age bracket.

Although older citizens may have higher levels of overall consumption and homeownership, when controlling for homeownership, the consumption patterns of younger homeowners are more responsive to changing housing prices. In one variation of their model, the researchers estimate that the average elasticity of consumption spending to house prices is 0.47, but is as high as 0.6 for homeowners in their 20s. In other words, the authors predict that, if a young person’s home increases in value by $1,000, the owner will increase her spending by $600.

An important feature of this elasticity is that younger homeowners are more likely to finance their homes with debt. Because the young homeowners have fewer total assets other than their houses, increased home prices represent a higher proportional increase in net worth—so, feeling richer, they spend more, relative to an older homeowner whose house increased in value by the same amount.

This research deepens the understanding of individual household behavior in response to movements in housing prices, particularly for younger, liquidity-constrained homeowners. The implications of this are particularly relevant in developed countries where there are increases in household debt, which could be caused by concurrent increases in housing prices. This seems to be a key feature of the most recent American financial crisis.

When policymakers consider interventions in the housing market that are likely to affect the price of housing, they should be aware of the likely effects on consumption as well. Changes to housing prices can in turn affect spending and savings at the household level, which feeds into larger economic stability at a macroeconomic level.

Article Source: Berger, David, Veronica Guerrieri, Guido Lorenzoni, and Joseph Vavra. “House Prices and Consumer Spending.“ National Bureau of Economic Research Working Papers 2015.

Featured Photo: cc/(Todd Bartusek)