Wednesday, February 22, 2012

The housing bubble: fooled by efficiency

In retrospect, the large rise in housing prices before 2007 looks suspect, many would even call this a bubble. But when you observe it in real time, it is much more difficult to judge whether house price inflation is excessive, although economists have been calling for it. A characteristic of many bubbles is that expect prices to increases forever, while it clearly cannot be true, at least in this magnitude. So somehow people are fooled.

Brian Peterson rationalizes this in a search model where the search frictions allow prices to deviate from their fundamental. The innovation of this model is that people are assumed to believe that price are not affected by the search frictions: they think markets are fully efficient.This means that instead of bargaining over the house price level, buyers and sellers bargain over house price increases. One interesting consequence of this is that turn-over volume and price inflation are then positively correlated. And once you quantify the model, about 70% of he price run-up can be explained by this "foolish" behavior.

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