House Prices and Consumption: A Micro Study

Empirical evidence shows that house prices and consumption are closely synchronized. However, previous contributions disagree over the causes of this link. According to the life cycle model, households plan lifetime consumption based on their expectations about the development in their total wealth, including housing wealth, and households should only react to innovations in house prices. However, the previous literature has promoted three alternative explanations. One explanation is that the observed correlation may be due to “common causality” since rising house prices may be correlated with expectations on general productivity increases in society. Other contribution focus on the fact that housing serves as collateral, implying that credit constrained households may show excess sensitivity to house price changes. Finally, extensive financial liberalizations in many countries may have stimulated both house prices and consumption in general. This paper investigates whether the wealth effect can explain the development in consumption and house prices in Denmark in 19871996. The paper explores a rich panel data set with information on individual house ownership, income and wealth for 10 percent of the Danish population. We construct a panel of imputed consumption based on the imputation method developed by Browning and Leth-Petersen (2003). In order to investigate the life cycle model and in particular the wealth explanation, it is essential to distinguish between expected and unexpected changes in housing capital and income. We model households’ expectations on the development in house prices and income in order to differentiate between innovations to housing wealth and human capital at the individual level. Having access to such a rich panel data set is unique by international standards. One of the main advantages is that we can differentiate between the reactions of younger and elderly households, between long-term renters and house owners, and between creditconstrained and unconstrained households. In 1993, a financial liberalization reform as well as a tax reform took place. We therefore divide the analysis into two periods: Before 1993 and after 1993. We find no significant response to changing house prices before 1993. After 1993, we find a positive effect of both anticipated house price changes and house price shocks. The effect is more pronounced for younger than for older households. This result, which is evidence against the wealth explanation, is in line with the findings of Attanasio et al. (2005) and Attanasio and Weber (1994). The positive effects of house prices on consumption is most pronounced for liquidityconstrained households, which suggests that housing is an important collateral for households who are borrowing-constrained.