1. Summer 2011 Macroeconomics – Lecture 1 Extra Slides Macroeconomics – Lecture 1 Extra Slides 1

2. 2 Understanding Housing Prices

3. Average Annual Real Housing Price Growth By US State State1980-20002000-2007State1980-20002000-2007 AK-0.0010.041MT0.0030.049 AL0.0000.024NC0.0080.022 AR-0.0090.023ND-0.0100.033 AZ-0.0020.061NE-0.0020.007 CA0.0120.066NH0.0140.041 CO0.012 NJ0.0150.058 CT0.0120.044NM-0.0020.043 DC0.0100.081NV-0.0050.060 DE0.0110.053NY0.0200.051 FL-0.0020.068OH0.003-0.001 GA0.0080.019OK-0.0190.019 HI0.0040.074OR0.0090.051 IA-0.0010.012PA0.0080.042 ID-0.0010.047RI0.0170.059 IL0.0100.030SC0.0070.025 IN0.0020.020SD0.0020.025 Average0.0110.036 3

4. Typical “Local” Cycle 4

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7. 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

8. 8 Real House Price Changes By State: 1997-2005 (x-axis) vs. 2005 – 2009 (y-axis)

9. Typical “Country” Cycle (US – OFHEO Data) U.S. Nominal House Price Appreciation: 1976 - 2008 9

10. Typical “Country” Cycle (US – OFHEO Data) U.S. Real House Price Appreciation: 1976 - 2008 10

11. Country1970-19992000-2006Country1970-19992000-2006 U.S.0.0120.055Netherlands0.0230.027 Japan0.010-0.045Belgium0.0190.064 Germany0.001-0.029Sweden-0.0020.059 France0.0100.075Switzerland0.0000.019 Great Britain0.0220.068Denmark0.0110.065 Italy0.0120.051Norway0.0120.047 Canada0.0130.060Finland0.0090.040 Spain0.0190.081New Zealand0.0140.080 Australia0.0150.065Ireland0.0220.059 Average1970-19990.012 2000-20060.046 Average Annual Real Price Growth By OECD Country 11

12. Country Cycles – The U.S. is Not Alone 12

13. Country Cycles – The U.S. is Not Alone 13

14. Country Cycles – The U.S. is Not Alone 14

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16. 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. 16

17. 17 Equilibrium in Housing Markets Demand PHPH QHQH Fixed Supply (Short Run)

18. 18 Equilibrium in Housing Markets Demand PHPH QHQH Fixed Supply (Short Run) PH’PH’

19. 19 Equilibrium in Housing Markets Demand PHPH QHQH Fixed Supply (Short Run) PH’PH’ Demand shocks cause large price increases when supply is fixed

20. 20 Equilibrium in Housing Markets Demand PHPH QHQH Fixed Supply PH’PH’ Supply Eventually Adjusts PH”PH”

21. 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. 21

22. 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) 22

23. 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) 23

24. Country1970-19992000-2006Country1970-19992000-2006 U.S.0.0120.055Netherlands0.0230.027 Japan0.010-0.045Belgium0.0190.064 Germany0.001-0.029Sweden-0.0020.059 France0.0100.075Switzerland0.0000.019 Great Britain0.0220.068Denmark0.0110.065 Italy0.0120.051Norway0.0120.047 Canada0.0130.060Finland0.0090.040 Spain0.0190.081New Zealand0.0140.080 Australia0.0150.065Ireland0.0220.059 Average1970-19990.012 2000-20060.046 Average Annual Real Price Growth By OECD Country 24

25. 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). 25

26. U.S. OFHEO Housing Cycle - Levels 26

27. 27 Bonus Material: The Yield Curve

28. 28 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 sloping Data on U.S. treasury yields from late 2004 Maturity (in years)

29. 29 Yield Curve Mechanics Consider a two period model Define the interest rate on a one year treasury starting today as i 0,1 Define the interest rate on a two year treasury starting today as i 0,2 What is the relationship between one year treasuries and two year treasuries? Appeal to theory of arbitrage. If arbitrage holds, then by definition: (1 + i 0,2 ) 2 = (1 + i 0,1 ) * (1 + i 1,2 ) where i 1,2 is the interest rate on a one year treasury starting one period from now.

30. 30 Shape of the Yield Curve: Macro Explanations Solve for long interest rates (i 0,2 ) as a function of short rates: i 0,2 = [(1+i 0,1 ) * (1+i 1,2 )] 1/2 – 1 Question:When does the yield curve slope up (i.e., i 0,2 > i 0,1 )? Answer: When i 1,2 > i 0,1

31. 31 Shape of the Yield Curve: Macro Explanations When does i 1,2 > i 0,1 ? Remember: i = r + π e + ρ (or, with time subscripts, i 0,1 = r 0,1 + π e 0,1 + ρ 0,1 ) where ρ is a risk premium To start, assume risk free assets (ρ = 0) So, if r is held fixed over time (i.e., r 0,1 = r 1,2 ) then the yield curve will slope up if π e 1,2 > π e 0,1. Increasing inflation will cause the yield curve to slope up (all else equal)! Also, if π e is fixed over time (i.e., π e 1,2 = π e 0,1 ) then the yield curve will slope up if r 1,2 > r 0,1. Higher future real rates will cause the yield curve to slope up (all else equal).

32. 32 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, i 1,2 > i 0,1 if ρ 1,2 > ρ 0,1 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

33. 33 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.

34. 34 Current Yield Curve for U.S. Treasuries (12/1/09)

35. 35 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.

36. 36 Current “10”- “2” Year Treasury (Through 2/09)