No. 10/2012: Testing for rational bubbles in the housing market

Abstract

This paper investigates the presence of a bubble in the US housing market prior to the 2007 subprime mortgage financial crisis. The relationship between housing prices and rental prices, known as the price-rent ratio, is an important measure of a potential deviation between housing prices and its fundamental value. Additionally, the interest rate is taken into account since it is an important factor in determining demand for housing mortgages and thereby influence housing prices. These relationships are then put into a theoretical model framework. The empirical evidence suggests that there was a bubble in the housing market prior to the financial crisis, even when controlling for the decreasing interest rate in the period. Hence, the econometric procedures used in the analysis may be relevant for monitoring the housing market.
JEL Classification: E31, G12, R21, C32
Keywords: Rational bubbles, Rent-price ratio, House prices, Interest rates, Cointegration, Vector autoregression.