FRB: Housing Wealth and Consumption (2024)

Matteo Iacoviello2

NOTE: International Finance Discussion Papers arepreliminary materials circulated to stimulate discussion andcritical comment. References in publications to InternationalFinance Discussion Papers (other than an acknowledgment that thewriter has had access to unpublished material) should be clearedwith the author or authors. Recent IFDPs are available on the Webat http://www.federalreserve.gov/pubs/ifdp/. Thispaper can be downloaded without charge from the Social ScienceResearch Network electronic library at http://www.ssrn.com/.

Abstract:

Housing wealth is about one half of household net worth, and consumption is a considerable fraction (about two thirds) of Gross Domestic Product in the United States. Empirically, movements in housing wealth are associated with movements in consumption in the same direction. This observation has led many economists, commentators and policy makers to study how housing wealth and consumption are linked together. A sizeable portion of the comovement between housing wealth and consumption reflects common factors driving both variables, rather than the "wealth effect" of the former on the latter; however, a growing body of evidence suggests that the comovement is larger in developed financial markets and in the presence of liquidity constraints.

Keywords: Borrowing constraints, consumption, consumption function, household budget

JEL classification: C2, E2, G1, R2

At the aggregate level, housing wealth measures the market valueof all the residential assets located in a particular country.According to this definition, housing wealth of U.S. households atthe end of 2008 was 25.4 trillion dollars. Housing wealth is aboutone half of total household net worth (which is 52.9 trilliondollars), and is larger than the Gross Domestic Product (14.4trillion dollars). Moreover, since financial wealth is moreunequally distributed than housing wealth, housing wealth accountsfor almost two thirds of the total wealth of the median household.Table 1.1 lists the balance sheet of the household sector in theUnited States at the end of 2008 using data from the Flow of FundsAccounts of the United States (FOF), using a breakdown of totalhousehold assets that differentiates housing capital from otherforms of wealth. A large fraction (80 percent) of housing wealth ismade up by the stock of owner-occupied homes. The remaining 20percent (residential real estate held by nonfarm noncorporatebusinesses) is made up by the rental housing stock.

Figure 1 plots household consumption expenditures in the UnitedStates along with wealth divided into housing wealth andnon-housing wealth. The series have been converted in 2005 billionsof dollars using the deflator for personal consumptionexpenditures. The stock of housing wealth is large and moves slowlyover time, but it exhibits a sharp increase between 1997 and 2005,followed by a bust between 2005 and 2008: size and persistenceexplain why changes in housing wealth are potentially an importantcandidate for understanding trends and cycles in aggregateconsumption expenditures.

Figure 2 plots annual changes in housing wealth and personal consumption expenditures in the United States from 1952 to 2008. The two variables tend to move together in post-world war II U.S. history. Their contemporaneous correlation is 0.47. This correlation is larger than the correlation between consumption and the residual components of household wealth: for instance, the contemporaneous correlation between changes in financial wealth and consumption equals 0.38.

The comovement between housing wealth and consumption poses a challenging question for macroeconomists, policymakers and commentators. Do fluctuations in consumption reflect fluctuations in housing wealth, or are both variables determined by some other macroeconomic factor that moves them, such as technological change, movements in interest rates, or other factors that contribute to business cycle fluctuations?

Table 1.1: Composition of Household Wealth in the United States

U.S. Households' Balance Sheet	2008 Billion $	FOF entry
AAssets	67,134	B.100:1
BReal Estate (Owner-Occupied Homes)	20,398	B.100:3
CResidential Real Estate of Noncorporate Business (Rented Homes)	4,964	B.103:4
DOther Tangible Assets	4,779	B.100:2 less B.100:3
EFinancial Assets less Residential Real Estate of Noncorp. Business	36,992	B.100:8 less B.103:4
FLiabilities	14,216	B.100:31
GHousehold net worth	52,917	AG
G Household net worth: Housing wealth	25,362	B+C
G Household net worth: Non housing wealth	27,555	D+EG

Figure 1.1: Housing Wealth, Consumption and Non-Housing Wealth in the United States From 1952 to 2008. The Series are Expressed in 2005 Billiions of Dollars.

Figure 1.2: Annual Changes in Housing Wealth and Consumption in the U.S., From 1952 to 2008.

A standard macroeconomics textbook contains a section presentingthe economy's consumption function. In this consumption function,the standard determinants of consumption are wealth andpermanent income , and the consumption function readsas follows:

(1)

where and measure respectively the marginal propensity to spend out of wealth and permanent income. This equation can be obtained as the solution to a problem where individuals maximize utility over time given a set of intertemporal trading opportunities, under very special assumptions about the set of trading opportunities and about the nature of the income process that the individual faces. An equation such as (1) dates back in the history of economic thought to at least Keynes, and was given prominence in the seminal work of Milton Friedman and Franco Modigliani.

When total wealth is broken down into housing and non-housing wealth , a generalizationof the above equation that allows for different marginalpropensities to consume of housing and non-housing wealth can bewritten as:

(2)

It is typical to interpret the coefficient in equation (2) as measuring the "housing wealth effect" . At the basic level, in fact, this equation states that if housing wealth were to change by, say, 1 dollar, consumption should change by dollars. This equation provides the basis to think about the connection between housing wealth and consumption. However, it is entirely silent about the reasons why housing wealth moves. One important caveat in interpreting the results from this equation is that, while it is reasonable to interpret part of changes in the two right-hand side variables as exogenous at the individual level (bequests, lottery winnings, unemployment spells, gentrification and deterioration of a neighborhood are somewhat outside the control of the individual), the interpretation of this equation at the aggregate level is more complicated, since, to a large extent, all variables of equation (2) are jointly determined.

Movements in non-housing wealth, for instance, might eitherreflect a new view of future profits or occur because marketparticipants apply a different set of discount factors to thoseexpected profits, where the discount factors incorporate bothrisk-free interest rates and equity premiums. From a theoreticalstandpoint, these movements could have different effects onhousehold spending. The same reasoning applies to housing wealth:changes in the value of the housing stock might reflect genuineshifts in tastes between housing and consumption goods, or couldresult from changes in availability of residential land, or frommovements in sectoral technologies. It is reasonable to assume thatall these changes could affect consumption, but their effects mightdiffer.

The empirical literature (surveyed in the next section) grappleswith the obvious identification problem of separating endogenousfrom exogenous movements in housing wealth. The theoreticalliterature studies instead the question of whether a housing wealtheffect exists, what it means, and how to think about it.

3.1A Basic Model

To illustrate the ideas, this section considers a simple modelof consumption and housing choice. A household lives forever andhas preferences defined over current and future non-housingconsumption and housing services That is, the household problem is defined by:

(3)

where is the household discount factor, and is the expectation operator. This preference specification is standard in models of household behavior. Life-cycle and bequest considerations, endogenous labor supply, non-separability between housing and consumption, and housing tenure choice are ignored here. The household faces the following budget constraint in any period :

(4)

where is the price of housing, is non-housing wealth (for instance, shares in a firm orholdings of government debt), is the return onnon-housing wealth, is labor income. Inequation (4), the right-hand side measurestotal resources available to the household at the end of the period These resources, in the absence ofportfolio adjustment costs, can be used for consumption, housingwealth accumulation and non-housing wealth accumulation. Settingaside general equilibrium considerations, one can treat and asexogenous (and possibly random), and assume that the householdchooses plans for consumption housing and financial wealth In this simple framework, random changes in and can proxyrespectively for housing wealth shocks, non-housing wealth shocks,and income shocks. For given initial conditions, the solution tothe household problem can then be rearranged to express optimalhousehold consumption as a function of lagged non-housing wealth, housing wealth and innovations to and It has the interpretation of aconsumption function.

What are the implications for non-housing consumption of a shockto housing wealth in this model? To gain some intuition, considerthe simplest possible case where the household, because of largeadjustment costs to housing, does not change house between twoconsecutive periods: for every .It is easy to see that changes in areirrelevant for consumption behavior of this household, since in every period, sothat housing wealth disappears from the household budgetconstraint. Intuitively, higher housing values () result in higher housing costs () that exactly offset the housing wealth effect onnon-housing consumption; when rises, wealth inunits of consumption increases, but, unless the individual changeshousing expenditures, housing wealth does not imply largerconsumption. This basic logic is what leads Buiter (2008) to assertthat housing wealth is not net wealth, unless individuals decreasetheir housing consumption in response to housing price changes.

If the household can change housing consumption between twoperiods ( needs not to equal ), an additional effect kicks in. When house pricesrise, the so-called substitution effect will cause households toreduce their demand for housing, and will free up resources thatcan be spent on non-housing consumption. In this scenario, theimmediate effect of an increase in housing wealth is that ofstimulating consumption. The interpretation of the rise inconsumption, however, is subtle: part of the rise in consumptiondoes reflect the result that wealth, measured in units ofconsumption, is larger, so that the individual will optimallyreallocate part of the larger wealth among all expenditurecategories. Part of the rise in consumption, instead, simplyreflects the economics of asset substitution: the household can nowachieve higher utility by consuming less housing and morenon-housing consumption goods than before.

3.2Extensions

What is missing from the basic theory above?

1. The simple theory above makes the extreme assumption thatchanges in the price of housing are purely exogenous. To see whymodifying this assumption might change the results, consider thecase where changes in the price of housing are the consequence of ashift in tastes between non-housing and housing goods: forinstance, individuals might decide that they prefer to live inlarger and nicer homes rather than dining out: under thisassumption, it is possible that increases in the price of housingare associated with lower consumption, since the change in houseprices is the consequence of a shift in preferences away fromconsumption goods. Empirically, evidence in favor of a mechanism ofthis kind comes from the observation (at least in the UnitedStates) that movements in housing prices are positively correlatedwith movements in housing investment: this evidence would seem tosupport the idea that movements in housing prices (and wealth) arethe consequence of shifts in housing demand, rather than housingsupply.


2. Another consideration that is missing from the basic story isthe presence of borrowing constraints. The structure of financialmarkets in many developed economies implies that households haveeasy access to housing wealth through second mortgages, home equityloans, or home equity lines of credit. If liquidity-constrainedhouseholds - who are believed to have a high marginal propensity tospend on average - can borrow more whenever their housing wealthrises, this channel is likely to lead to a larger correlationbetween movements in housing wealth and movements in aggregateconsumption. Moreover, one can expect larger aggregate effects fromchanges in housing wealth since housing wealth is more evenlydistributed across the population than non-housing wealth: ifrelatively poor people have higher than average propensity toconsume, the aggregate consumption response to changes in housingwealth might be larger than otherwise.


3. The basic model also sidesteps life-cycle and housing tenureconsiderations. The representative household of the model displaysa profile of housing consumption that is constant over time. Inreality, the way consumption is connected to movements in housingwealth should also depend on whether individuals expect to modifytheir housing consumption in the future. Cross-sectional data showthat housing wealth typically increases over the life cycle, beforeflattening out at a relatively old age. This is true both at theextensive margin (home ownership rates increase with age) and atthe intensive margin (the average size of owner-occupied housesincreases with age). Taking these elements into consideration, oneshould expect that life-cycle considerations should imply anegative response of consumption to increases in aggregate housingprices, since - to the extent that renters plan to becomehomeowners at some point of their life, or homeowners plan to moveto larger homes - higher housing prices require larger savings thanotherwise if individuals are planning to buy a larger home.


4. A final aspect to consider is how persistent changes in housingwealth are relative to changes in other forms of wealth.Historically, changes in housing returns have been more persistentthan changes in the return to, say, stockmarket wealth. Householdsconsumption might respond more to a given size change in housingwealth if this change is not expected to reverse quickly.

3.3Taking Stock

A message from the basic theory is that, after solving thehousehold intertemporal optimization problem, one can derive anaggregate consumption function where consumption is expressed as afunction of income and wealth, and where the marginal propensity toconsume out of housing wealth is positive or negative depending onthe underlying characteristics of the economy.

In a more realistic setting, however, especially when the goalis to model the economy as a whole (rather than the behavior of asingle economic agent), one should assume that wealth isendogenous, and that its fluctuations are driven by current orexpected movements in technology, tastes, taxes, or some otherunidentified economic fundamentals. These fundamentals, in turn,may affect at the same time both consumption and wealth itself,thus making any statement about links from wealth to consumption(or vice versa) hard to interpret.

Yet central bankers, practitioners and policymakers routinelythink of movements in wealth as exogenous, mostly because thesemovements are hard to predict or explain based on movements inreadily available observable variables that one can regard aspurely exogenous.

4.1The Conventional Wisdom

A simple regression on quarterly United States data for theperiod 1952.I-2008.IV of:

where , and measure respectively consumption, housing wealth and non-housing wealth, and is the first difference operator, yields the following coefficients (standard errors below):

More sophisticated regressions yield similar results, at leastqualitatively if not quantitatively. This simple regression has thevirtue of being simple, easy to estimate, replicable andstraightforward to interpret. According to this regression, theelasticity of consumption to housing wealth is 0.14, after controlling for movements in non-housing wealth(the elasticity of consumption to non-housing wealth is lower, at0.06). These estimates are more oftenconverted into dollar-to-dollar estimates using the fact that, inthe sample in question, the average ratio of housing wealth toannual consumption is about 2.3, and the averageratio of non-housing wealth to annual consumption is about2.75. A one dollar increase in housing wealththen generates an increase in annualized consumption of about6 cents, and one dollar increase innon-housing wealth generates an increase in consumption of about2 cents.

The results of this simple regression are the basis for a seriesof wisdoms about wealth effects and the basis for thinking abouthousing wealth and consumption. In particular, the largersensitivity of consumption to housing wealth is one of the manyreasons why policymakers might be more worried about changes inhousing than non-housing wealth.

4.2Studies Based on Aggregate Time-Series Data

Perhaps one of the most prominent studies of the link betweenhousing wealth and consumption is the FRB/US model, which is one ofthe econometric models of the U.S. economy used by the FederalReserve. One of the model blocks describes household consumptionbehavior as a function of total wealth and its composition. Thismodel predicts, among other things, a marginal propensity toconsume out of net tangible assets (housing wealth and consumerdurables less home mortgages) which ranges between 5and 10 cents on the dollar (see for instanceBrayton and Tinsley, 1996).

Several studies have reviewed the literature and providedadditional estimates of the so-called housing wealth effect. Thebroad consensus from the literature based on time-series data isnot very different from the FRB/US model, with some studies findinglarger elasticities for housing wealth, and some other studiesfinding the opposite. Poterba (2000) surveys a variety of estimatesfrom the literature.

More recent studies corroborate the findings from the empiricalliterature of the 1990s. Carroll, Otsuka and Slacalek (2006)propose a time-series based method that exploits the sluggishnessof consumption growth to distinguish between immediate and eventualwealth effects. Using U.S. data, they estimate that the immediate(next-quarter) marginal propensity to consume from a $1 change in housing wealth is about 2 cents,with an eventual effect around 9 cents, substantiallylarger than the effect of shocks to financial wealth.

Case, Quigley and Shiller (2005) find a strong correlationbetween aggregate house prices and aggregate consumption in a panelof developed countries. According to the central estimates, a1 percent increase in housing wealth increasesconsumption by roughly 0.11 percent in theinternational panel. For a panel of U.S. states, an updated versionof their 2005 paper (Case, Quigley and Shiller, 2011) reportselasticities of consumption to housing wealth that range from0.03 to 0.18, with acentral estimate of 0.08.

The main problem with studies based on aggregate data is thatsuch data do not rule out alternative explanations for the timeseries correlation: either indirect wealth effects or reversecausation running from changes in household saving to changes inwealth. Iacoviello and Neri (2010) address this problem in astructural equilibrium model where both consumption and housingwealth are endogenous, and are driven by movements in technology,preferences, monetary policy. They show that their modelquantitatively replicates the positive correlation in the databetween consumption growth and housing wealth growth. The bulk ofthis correlation simply captures common factors that move the twovariables in the same direction, such as shifts in preferences,interest rates, or technology. However, a non-negligible portion ofthis correlation reflects the contribution of liquidityconstraints. This result echoes the conclusions of Muellbauer andMurphy (2008), who argue that housing collateral and downpaymentconstraints are the key to understanding the role of house-pricevariations in explaining medium-term consumption fluctuations.

4.3Studies Based on Micro Data

A growing literature has used household-level data to connectmovements in consumption and movements in housing wealth. One ofthe main questions in this literature is to study how householdsrespond to changes in the value of their housing wealth. A centralissue concerns how to identify movements in housing wealth that areorthogonal to other factors that might also affect consumption.

Campbell and Cocco (2007) study micro data from the UK FamilyExpenditure Survey from 1988-2000. They use repeated cross-sectionsof household expenditure data and regional home price informationto estimate a small, positive consumption response to home pricesfor young homeowners, and a large positive response for oldhomeowners. Using mean home values and consumption as reported intheir paper, this translates into marginal propensities to consumeout of housing wealth of 0.06 for young homeowners, and0.11 for old homeowners.

Mian and Sufi (2009) investigate how existing homeowners respondto the rising value of their home equity, which they refer to asthe home equity-based borrowing channel. They use landtopography-based housing supply elasticities in order to identifyexogenous variations in house price growth across differentgeographical areas and individual-level data on homeowner debt anddefaults from 1997 to 2008. They show that existing homeownersincrease their borrowing significantly in response to changes intheir home equity, and use the extra borrowing mainly for realoutlays, such as consumption or home improvements.

Housing wealth is a major component of household wealth. Housingwealth is linked to non-housing consumption through the logic andalgebra of the budget constraint: by moving to a smaller or largerhouse, a household can free up or use resources that wouldotherwise go into non-housing consumption or other forms of saving.Empirically, housing wealth and consumption tend to move together:this could happen because some third factor moves both variables,or because there is a more direct effect going from one variable tothe other. Studies based on time-series data, on panel data and onmore detailed, recent micro data point suggest that a considerableportion of the effect of housing wealth on consumption reflects theinfluence of changes in housing wealth on borrowing against suchwealth.

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Iacoviello, Matteo (2005) 'House prices, borrowing constraints, and monetary policy in the business cycle.' American Economic Review 95(3), 739–764

Iacoviello, Matteo, and Stefano Neri (2010) 'Housing market spillovers: Evidence from an estimated dsge model.' American Economic Journal: Macroeconomics 2(2), 125–64

Mian, Atif R., and Amir Su… (2009) 'House prices, home equity-based borrowing, and the u.s. house-hold leverage crisis.' NBER Working Papers 15283, National Bureau of Economic Research, Inc, August

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1.This paper was written for the "International Encyclopedia ofHousing and Home," to be published by Elsevier in 2011. I thankAndrea Raffo, Matteo Cacciatore, Morris Davis and Kim Kyung-Hwanfor helpful discussions. The views in this paper are solely theresponsibility of the author and should not be interpreted asreflecting the views of the Board of Governors of the FederalReserve System or of any other person associated with the FederalReserve System. Return to text

2. Matteo Iacoviello, Division ofInternational Finance, Federal Reserve Board, 20th and C St. NW,Washington, DC 20551. Email: [emailprotected].Return to text

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