RDP 2018-04: DSGE Reno: Adding a Housing Block to a Small Open Economy Model 5. The Transmission of Housing Shocks

As shown above, adding a housing sector to the existing DSGE model helps us to match certain patterns in the data, such as the relative responsiveness of housing investment to monetary policy shocks. Another benefit is that it also allows us to examine how shocks to the housing sector are transmitted through the economy.

The housing sector features a number of shocks that, for the sake of interpretation, we split into two classes: shocks to the stock of housing, such as housing preference shocks and housing investment shocks; and shocks to housing services, such as shocks to productivity in the housing services sector. We study below the model-implied responses of the endogenous variables to each of these shocks and compare where appropriate to the predictions of the canonical model of Iacoviello and Neri (2010).

5.1 Shocks to the Housing Stock

In the model, negative housing investment shocks imply that agents need to use up more consumption goods to produce a given quantity of new housing stock. In this sense, it is very similar to the housing technology shocks in Iacoviello and Neri (2010). While the shock directly implies some exogenous increase in construction costs, it can more generally be interpreted as some exogenous shock that lowers the level of housing investment.

Figure 13 shows the response of selected variables to a housing investment shock that lowers housing investment by 5 per cent. The lower housing investment, and so lower demand for intermediate goods, causes GDP to fall by about ½ per cent. Total investment and consumption also fall. The latter is in contrast to Iacoviello and Neri (2010), who find that consumption rises in response to a negative housing (investment) technology shock. The difference reflects the fact that in Iacoviello and Neri, housing and other consumption are substitutes (abstracting from collateral effects), in that agents can raise their utility by consuming more of one or the other. While this is also the case in our model, the fact that the housing capital stock is used to produce housing services, which make up part of the consumption bundle, creates an offsetting ‘complimentary’ relationship between the housing stock and consumption.

On the nominal side, inflation declines slightly and the cash rate is lowered by around 10 basis points. The modest fall in inflation is the result of offsetting forces in the economy. The contraction in housing investment supports the housing-related components of inflation by lowering the supply of housing, while the decreased demand for intermediate goods lowers inflation in the non-tradeable and tradeable sectors (Figure 14). The combined effect is a modest fall in overall inflation.

Housing preference shocks are exogenous shocks to the demand for the stock of housing which allow for a greater gap between the rate of return on housing and that on other capital. Such shocks can be interpreted in different ways, including as: a change in the taxation treatment of housing; a change in expectations regarding future capital gains on housing; or a change in demand from foreign buyers.^[22]

Figure 13 also shows the response of selected variables to a housing preference shock that causes a 5 per cent decline in housing investment. The responses are very similar to those for a housing investment shock. This does suggest that the model may have difficulties separately identifying these two shocks, which is somewhat reflected in our estimation results where we observe some signs of weak identification for the preference shock parameters. Nevertheless, we include both in the model as they are likely to have quite different implications if we consider anticipated shocks in scenario analysis.

In both cases, households will have an incentive to decrease investment in advance of the negative shock due to the investment adjustment costs and, to a lesser extent, habit persistence in the housing capital stock in households' utility functions. But, in the case of an investment shock, they will have an offsetting incentive to increase investment immediately, when it is relatively ‘cheap’. As such, the magnitude and dynamics of the investment response will differ somewhat in the two cases.^[23] Therefore, having both shocks enables us to perform a more diverse range of scenario analyses.

The responses to the housing preference shock in our model are also qualitatively similar to those for a housing preference shock in Iacoviello and Neri (2010). In their baseline model, consumption declines following a negative housing preference shock. However, in their model without collateral constraints, consumption rises. Our model, which also does not include collateral constraints, matches their baseline model, which includes collateral constraints. Therefore, our specification can match some of the qualitative predictions arising from a more complex model with heterogeneous agents and a banking system.

5.2 Shocks to Housing Services

Our model also allows for exogenous changes in the productivity of the housing services sector. That is, more or less housing services being produced with the same level of housing stock and labour. This could, for example, capture changes in the composition of the housing stock such as a shift towards apartments or smaller houses, that produce more housing services per dollar of housing stock. There is no equivalent shock in the Iacoviello-type framework.

Figure 15 shows the responses of selected variables to a technology shock that lowers housing investment by 5 per cent. Lower productivity in the housing services sector leads to lower production and investment in that sector, and in aggregate. It also pushes up prices of housing services substantially, which flow through to higher aggregate inflation and therefore a higher cash rate.

Footnotes

In interpreting the shock as a change in demand from foreign buyers, we would be abstracting from any potential exchange rate effects stemming from changes in capital inflows and outflows. [22]

The degree of difference will depend on a number of factors, including: the degree of habit persistence; the size of the investment adjustment costs; how far in the future the anticipated shock will occur; and the size and duration of the shock. [23]