Self-fulfilling Beliefs and Bounded Bubbles in the U.S. Housing Market∗

This paper provides an equilibrium framework to organize the following empirical observations in the U.S. housing market from 1975 to 2007: (i) housing tenure and vacancies were approximately constant, (ii) rents were approximately constant, and (iii) in the late 1990s there was a large house price appreciation. Borrowing ideas from search and matching theory, and closing the model with self-fulfilling beliefs about the housing market, the model generates a house price bubble as a consequence of multiple underlying steady state equilibria. To select a deterministic equilibrium, household confidence is assumed to take one of two sunspot-driven values: normal or exuberant. When confidence is normal, both rents and house prices are low. When confidence is exuberant, both rents and house prices are high. Randomization over these two equilibria implies a substantial increase in house prices as the probability of the exuberant state increases. The model can explain a house price bubble as a rational expectations equilibrium driven by self-fulfilling beliefs. ∗This version: February 20, 2011. I am truly indebted to Roger Farmer for his supervision and encouragement. I am also grateful to Lee Ohanian and Pierre-Olivier Weill for fruitful discussions. For helpful comments, I wish to thank Arpad Abraham, Andy Atkeson, Paco Buera, Ariel Burstein, Larry Christiano, Russell Cooper, Matthias Doepke, Christian Hellwig, Thomas Hintermaier, Matthew Hoelle, Alex Michaelides, Venky Venkateswaran, Daniel Waggoner, Mark Wright, Tao Zha and various seminar participants. I gratefully acknowledge financial support from the UCLA Ziman Center for Real Estate and the Max Weber Programme. †European University Institute; e-mail: [email protected]