Working Paper: NBER ID: w21667
Authors: David Berger; Veronica Guerrieri; Guido Lorenzoni; Joseph Vavra
Abstract: Recent empirical work shows large consumption responses to house price movements. This is at odds with a prominent theoretical view which, using the logic of the permanent income hypothesis, argues that consumption responses should be small. We show that, in contrast to this view, workhorse models of consumption with incomplete markets calibrated to rich cross-sectional micro facts actually predict large consumption responses, in line with the data. To explain this result, we show that consumption responses to permanent house price shocks can be approximated by a simple and robust rule-of-thumb formula: the marginal propensity to consume out of temporary income times the value of housing. In our model, consumption responses depend on a number of factors such as the level and distribution of debt, the size and history of house price shocks, and the level of credit supply. Each of these effects is naturally explained with our simple formula.
Keywords: House Prices; Consumer Spending; Permanent Income Hypothesis; Consumption Responses
JEL Codes: D14; D91; E21; E32; E6; R21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| House price shocks (R31) | Consumption behavior changes (D12) |
| House price shocks (R31) | Elasticity of aggregate consumption (E21) |
| House price shocks (R31) | Collateral effect (F69) |
| House price shocks (R31) | Substitution effect (D11) |
| House price shocks (R31) | Ordinary income effect (H31) |
| House price shocks (R31) | Endowment income effect (D15) |
| Endowment income effect (D15) | Perceived wealth increase (E21) |
| Implicit rental costs increase (G19) | Consumption behavior changes (D12) |