An Extrapolative Model of House Price Dynamics∗

A model in which homebuyers make a modest approximation leads house prices to display three features present in the data but usually missing from perfectly rational models: momentum at one-year horizons, mean reversion at five-year horizons, and excess longer-term volatility relative to fundamentals. Valuing a house involves forecasting the current and future demand to live in the surrounding area. Buyers forecast using past transaction prices. Approximating buyers assume that past prices reflect only contemporaneous demand, just like professional economists who use trends in housing prices to infer trends in housing demand. Consistent with survey evidence, this approximation leads buyers to expect increases in the market value of their homes after recent house price increases, to fail to anticipate the price busts that follow booms, and to be overconfident about the accuracy of their assessments of the housing market. ∗First draft: November 2014. We thank Kent Daniel, Ian Dew-Becker, Fernando Ferreira, Adam Guren, David Levine, Monika Piazzesi, Giacomo Ponzetto, Richard Stanton, Stijn Van Nieuwerburgh, Eric Zwick, and seminar participants at Kellogg, UPF/CREI, EUI, SED, SITE, and the NBER Summer Institute for helpful comments, and Nina Tobio and Aidan McLoughlin for excellent research assistance. Glaeser thanks the Taubman Center for State and Local Government at Harvard University and Nathanson thanks the Guthrie Center for Real Estate Research for financial support.