Working Paper: NBER ID: w21037
Authors: Edward L. Glaeser; Charles G. Nathanson
Abstract: A modest approximation by homebuyers leads house prices to display three features that are 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 do not adjust for the expectations of past buyers, and instead assume that past prices reflect only contemporaneous demand, as with a capitalization rate formula. 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 in their assessments of the housing market.
Keywords: house prices; naive inference; extrapolation; momentum; mean reversion
JEL Codes: D03; G02; R21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Naive inference (D83) | Overestimation of demand (E47) |
| Overestimation of demand (E47) | Price momentum (C69) |
| Past prices (P22) | Naive homebuyers' expectations (R21) |
| Naive homebuyers' expectations (R21) | Price corrections (D43) |
| Naive homebuyers' expectations (R21) | Momentum in house prices (E32) |
| Lack of adjustment for past buyers' expectations (D84) | Mean reversion in house prices (R31) |
| Naive buyers' inference rules (D83) | Excess volatility in house prices (E32) |
| Naive buyers' overestimation of demand (D12) | Overshooting during price booms (E32) |
| Naive buyers' underestimation of demand (D12) | Underestimating demand during busts (E32) |