HOUSING AND MACROECONOMICS Introduction Throughout economic literature is has been argued that housing investment is an important constituent

of GDP in any economy. But it has been subject to debate over academic researches, as to whether it is a major factor in explaining the macroeconomic fluctuations for an economy. Macroeconomic fluctuation for an economy is determined according to the volatility or lack of volatility in the GDP trend for an economy. GDP is defined as the aggregate demand for an economy, which is the sum of the total consumption, investment, government spending, and exports less imports (net exports). From the definition of GDP, it can be easily assumed that housing investment may be easily captured in one of the variables of GDP. Surprisingly, studies on this relation have proved otherwise. The upcoming constituents of this paper will analyse Housing price model, in correlation with the macroeconomic components of aggregate demand and supply, advocating housing prices are in direct correlation of the macroeconomic fluctuations in an economy; with summarising possible policies to counteract volatility in the economy as result of housing prices. Housing Prices Model As mentioned preliminarily, various studies have been conducted in the subject matter of this paper. The most notable research, relevant to this study is the research conducted by Meen. Meen (2007) in his paper "Ten New Propositions in UK Housing Macroeconomics: An Overview of the first year of the century" provides a structured analysis on the propositions concerning the relationship between housing and macroeconomy between the 1980s and 1990s in the United Kingdom. According to Meen (2007) the fundamentals that describe the dynamics of the housing prices, which is a determinant of housing investment, can be categorised in the following equation:

where, g(t) = real purchase price of dwellings = household marginal rate i(t) = market interest rate = depreciation rate of housing = rate of inflation The above function implies that housing prices, which determines the level of investment in the housing industry is a function of marginal propensity to consume, the margin of return on investment, interest rates, asset depreciation rates, and inflation levels in the economy. According to the above dynamic of prices in the housing market, the relationship between house prices and rent are determined to the following factors: y expectations of house prices determine the discount rate y credit market constraints has a significant impact on prices and the rent they are offered on y tax provisions related to housing

and transaction costs such as stamp duty

Furthermore, as per Meen (2007) there are absolutely no reason to deduct that there is any correlation between house prices and incomes. A comparative analysis of UK and US indicates a decreasing ratio of incomes and house prices in the US, due to high elasticity of supply. Whereas in the UK, the ratio is becoming fundamentally small, due to smaller elasticity of supply. The main highlight of Meen (2007) is that housing supply is the fundamental factor in housing market volatility and homeownership sustainability, which reasons the need for or against a housing policy. Housing and Macroeconomics The two fundamental components of macroeconomics and macroeconomic fluctuation are aggregate demand and aggregate supply, through which macroeconomic volatility is quantised in economic literature. Aggregate demand is defined as the total amount of goods and services demanded in the economy at a given overall price level and in a given time period. It is represented by the aggregatedemand curve, which describes the relationship between price levels and the quantity of output that firms are willing to provide. Normally there is a negative relationship between aggregate demand and the price level. Also known as "total spending". Aggregate supply is the total supply of goods and services produced within an economy at a given overall price level in a given time period. It is represented by the aggregate-supply curve, which describes the relationship between price levels and the quantity of output that firms are willing to provide. Normally, there is a positive relationship between aggregate supply and the price level. Rising prices are usually signals for businesses to expand production to meet a higher level of aggregate demand. In the early 20th century, less than 10% of all homes were owner-occupied, but by the early 21st century, this figure had risen to 70% - just above the EU average. By 2009, there were 21 million households in the UK. The housing market is unlike many other markets given the relative importance of second-hand transactions, compared with purchases of newly built property. According to the Meen's article in "The Sage Hnadbook of Housing Studies", only around 5% of transactions involve the purchase of new properties. Indeed, 95% of transactions involve the purchase of either 'old' property, which is defined as property built before the start of the Second World War, or 'modern' property, which is property built after 1945. The relative dearth of new property is one of the key factors driving the upward trend of UK property prices in the long run. The housing market for any economy is extremely important for two main reasons: Firstly, housing usually represents a households biggest single purchase, and a house represents the largest single item of consumer wealth. Secondly, changes in house prices can have considerable effects on the rest of the economy.

y y

A change in house prices affects the value of household wealth, creating a positive or negative wealth effect. A positive wealth effect means that, following a rise in house prices, the ratio of the market value of the property to the debt on that property, typically in the form of a mortgage, rises creating an increase in equity. This can trigger housing equity withdrawal (also known as mortgage equity withdrawal) and can be a significant boost to consumer spending. Changes in interest rates, which are a key policy tool to regulate the UK economy, often have a more significant effect on consumer spending in the UK than in the US. This is due to the relatively large proportion of home ownership in the UK, and the general spending sensitivity of UK consumers to interest rate changes, than the US on comparative scale

The long-term trend for UK house prices is upwards, but changes in house prices are extremely cyclical. The upcoming constituents of this paper will analyse the aggregate demand and aggregate supply dynamics of the housing prices model, whilst outlining a relationship with housing prices and macroeconomic fluctuation. Housing and Aggregate Demand The aggregate demand volatility for housing is determined by a number of factors, including house prices. As expected, there tends to be an inverse relationship between house prices and aggregate demand. As with all goods, the inverse relationship can be explained with reference to the income and substitution effect. This can be illustrated graphically as:

At higher prices, real incomes will fall reducing aggregate demand. In addition, at higher prices, the alternatives to owning a property, such as renting, appear more attractive and individuals are more likely to rent. When house prices are lower the reverse is true, with individuals encouraged to buy because of a rise in their real income and because renting seems less attractive. However, the aggregate demand for housing market is also partly speculative, so that a rise in prices can lead to a rise in demand as buyers anticipate a speculative gain. In addition to changes in price, which cause a movement along the aggregate demand curve for housing, other non-price factors are also important, and changes in these cause a shift in the aggregate demand curve. These include: y y y y y y y y y Population Incomes of Households Social Trends Interest Rates Availability of credit Fashion Price of Substitutes Buy to let demand and Speculative interests

Total demand for property is determined by population size and changes in the structure of the population caused by migration and long-term changes in the birth and death rates. An aging population will increase the overall aggregate demand for property. Changes in both the level of national income, and its distribution, can have a significant effect on the aggregate demand for housing. As houses are normal goods with a high income elasticity of demand, increases in income can trigger a larger percentage increase in housing demand. As their income rises many individuals switch from renting to home ownership, or move to bigger property. Some may buy a

second property as holiday homes, or to rent out. Hence, the aggregate demand curve housing will shift to the right as incomes rise. Social and lifestyle trends, such as a preference for late marriages, can alter the pattern of aggregate demand for houses. The preference for later marriages had led to an increase in the number of single households, and to a rise in the demand for small housing. Changes in general interest rates may be passed on by lenders such a building societies and banks, and this will also the amount of monthly repayments for those on variable-rate mortgages. Higher rates make property less affordable, and the aggregate demand curve will shift to the left. The recent UK interest rates are illustrated below:

Interest rates have been low in recent years, averaging around 4.5%, which has made property more affordable, and boosting demand. Rates started to fall dramatically in late 2008, to reach their lowest level on record. However, mortgage rates did not fall so dramatically, as lenders looked to maintain their liquidity and increase their profitability, and because many borrowers were on fixed-rate mortgages, not all could take advantage of low rates. The availability of credit is also important in determining the demand for property. During the banking and financial crisis of 2008-09, the supply of credit fell which reduced the demand for housing, and led to a fall in house prices. Owning property has become increasingly fashionable in the UK and US over the last 25 years. One reason is the number of television programmes featuring housing purchases, renovations, and 'makeovers', which have all increased interest in housing and the housing market. Furthermore, renting property is an alternative to ownership, and changes in rental prices can affect the demand for housing. The increase in the availability and popularity of buy-to-let mortgages in the 1990s created a new market for housing as an investment and gave a boost to an already buoyant market. This is particularly evident in the case for US. There is an important speculative element in the demand for housing. Housing developers and ordinary householders often base their current demand for housing on expectations of future price changes. Rising house prices encourage speculation and falling house prices discourage speculative buying. Housing and Aggregate Supply The aggregate supply of housing is partly determined by house prices, together with a number of underlying determinants. In terms of house prices, the relationship between aggregate supply and price is positive, with higher prices encouraging aggregate supply in an economy. Rising prices encourage house

builders to construct more housing, and existing owners are encouraged to sell. This can be illustrated graphically as:

The aggregate supply of housing is positively related to house prices, and the supply curve is upward sloping. However, aggregate supply is frequently inelastic because of time lags and legal complexities and, in the case of new-builds, because of the difficulty of obtaining planning permission. In addition to changes in price, which cause a movement along the aggregate supply curve for housing, other non-price factors are also important, and changes in these cause a shift in the aggregate supply curve. These include: y y y y y Availability of credit Costs Government legislation Subsidies Technology

As indicated, new house building depends upon the availability of land, which may be very limited in the short run. An increase in the availability of land in the long run will shift the aggregate supply curve to the right. Availability of labour is also important. For example, in unemployment would reduce aggregate supply of new houses. In the case of new-builds, construction costs may also have a significant effect on aggregate supply. These costs include raw materials and labour costs. A shortage of labour, for example, could push up the wage rate and increase building costs, which would cause the aggregate supply curve to shift to the left. Government legislation can also affect the aggregate supply of housing in a number of ways. The strict requirement for planning permission for new house building may deter house builders. Conversely, relaxation of regulations, as happened in the London Docklands, is likely to encourage building. Government can also tighten or relax restrictions on building in rural areas, such as the green belt. More recently, the UK government introduced Home Information Packs (HIPS) in an attempt to speed up the house-buying process. However, critics argue that it has added a new layer of bureaucracy into an already over-regulated market. Subsidies given to house builders are also likely to encourage aggregate supply, such as the subsidies given to builders of affordable homes for key workers, including police, fire, and ambulance workers. The application of new building methods, such as pre-fabrication, and the use of new building materials have increased the speed at which new houses are built, and hence increased the aggregate supply of houses. However, this has tended to increase the elasticity of supply of properties at the cheaper end of the market.

Housing and Equilibrium In microeconomic terms, house price reflect both demand and supply, and, as in all markets, equilibrium price will occur at the price that matches current demand to available supply. In the short run, supply is relatively inelastic given that it takes a long time to build new houses. Hence, increases in demand have an especially big effect on house prices. Over time, demand for housing in the UK has risen continuously while the supply has remained stable. UK house building in recent years has been one of the lowest when compared to the US, and this has contributed to the rising level of average prices. However, in macroeconomic terms, and econometric studies conducted by Meen (2007); interest rates are an increasingly important determinant of the demand for housing in the UK and US economy. A small fall in interest rates can trigger a large increase in the demand for housing. Lower interest rates lead to lower mortgage rates, and encourage new entrants as well people looking to buy second homes as an investment. With low interest rates, people with excess funds to invest will get a better rate of return by investing in property rather than from a bank deposit account. This additional demand drives up house prices, and macroeconomic volatility. Economic Trends in the Housing Market Meen (2007) has showed house prices exhibit three main features: y y y Rising average prices in the long run Considerable medium-term volatility, with house price bubbles, occasionally followed by dramatic price crashes Considerable price variations between different regions of the UK

The rising average prices and the long run increase in house prices are caused by demand for housing outstripping supply. It has been estimated that 175,000 more homes must be built each year to meet the future level of demand for housing. As previously noted, only around 5% of property transactions involve new properties. House prices have crashed twice in the last 20 years, between 1990 and 1992, and more recently between 2007 and 2009. As the economy came out of recession in 1992, house prices began to rise, and continued for a further 15 years. Over most of this period, house prices rose well above the general inflation rate generating a considerable wealth effect. However, during the mid-2000's house price inflation started to slow down, and prices starting falling during 2007. House prices continued to fall throughout 2008 and 2009, and again in 2011. A wealth effect refers to changes in household or corporate spending that can occur as a response to changes in the value of wealth. Wealth effects can be positive and negative. They are most commonly associated with changes in house prices, share and bond prices. While the average level of household wealth in the UK has risen over time, it is volatile, and the house price crashes of 1990 - 1993, and 2008 - 2009, led to a steep falls in wealth levels. Household spending is affected by changes in household wealth through a process called equity withdrawal, and changes in confidence levels.

Wealth can also be looked at in terms of liquidity, which is the ease with which an asset can be converted into cash. Cash is considered to be perfectly liquid, whereas fixed assets like machinery and premises are extremely illiquid. The macro-economic system needs considerable liquidity to facilitate the circular flow of income. The recent credit crunch, like previous economic disturbances, was triggered by sudden changes in the availability of liquidity. As banks, firms and households look to reduce their risks they often reallocate their wealth from illiquid forms to liquid forms. However, as they increase and protect their own liquidity, less liquidity is made available to others. In a sense, people hoard liquidity which perversely reduces liquidity in the whole macroeconomic system. For example, banks may call in loans or make fewer loans, and in turn, firms may hold fewer stocks and prefer to hold cash. To compound matters, anxious households may save more of their income, and hold more cash, which reduces spending on consumer goods, and further reduces liquidity. The general housing shortage is partly responsible for house price bubbles and subsequent crashes. Given the long term above-inflation rise in house prices, property represents a safe investment, both for homeowners, and for property developers, asset managers, and general investors. This is even more the case when alternative investment opportunities become less attractive, such as when interest rates are low, or when company profits and share prices are low, as occurred between 2007 and 2009. Rising property prices also attract speculators hoping to make a fast return. As speculators enter the market in increasing numbers, the probability of a bubble, and then a crash, also increases. The increased securitisation of mortgage debt created the means by which developers and speculators could build new properties, and sell them to high-risk, sub-prime, borrowers. The high-risk mortgage debt could be repackaged, and sold off to largely unwitting banks. This created an extreme form of moral hazard, which meant that many lenders blindly pursued short-term profits in the belief that their potential losses from loan defaults were fully covered. The long-term housing shortage and upward trend in house prices, also provided encouragement for first-time buyers to enter the market, and for investors and speculators to provide funds for home construction, and for lending to potential borrowers. This all works well when house prices do, indeed, rise, but when the bubble bursts the effect can be catastrophic, spreading shock waves across the national economy, and into other countries. The globalised nature of financial markets accelerated the speed of the financial crisis that followed the housing crash. House prices vary considerably across the UK, with highest average prices in London and the South East. Regional differences can be explained in terms of regional variations in demand and supply conditions. High average earnings, full employment, inward migration, relatively limited housing stock, and tight restrictions on new house building in UK account for high average prices in UK. In contrast, lower average wages, more housing stock, and easier planning means that average prices in many of the regions are relatively low. This regional disparity makes it difficult for individuals to move regions in search of work and reduces the geographical mobility of labour. The effect of house price changes; house price movements can have a number of consequences, perhaps the most important of which is the effect it has on household spending. Changes in property and other asset prices affect household spending in a number of ways. For example, an increase in asset values creates positive equity, which can lead to housing equity withdrawal and rising confidence. An asset's equity is the difference between the market price of the asset and the mortgage, or other debts, on the asset. For example, a property valued at 200,000, with an 80,000 mortgage has equity of 120,000. With positive equity, properties can be re-mortgaged so that

homeowners can use the equity to fund spending. Falling house prices reduce equity and may even create negative equity, especially for new homeowners, which creates negative consumer sentiment and is likely to lead to lower household spending. Changes in house prices also affect the distribution of wealth in the economy. During times of rapidly rising prices, those who own property will experience an increase in their wealth relative to those who rent accommodation. When house prices crash, new owners and those with large mortgages suffer in comparison with those who rent. However, a fall in house prices may, of course, enable the low paid to get a foothold on the property ladder. Policy Making in the Housing Market Policy making in the housing market should be directed towards policies increasing the supply of houses, policies to regulate demand, the affordability of housing, the case for rent controls, and the prevention of credit crunch in the housing market. Policies to regulate supply of housing can be outlined under the following criteria: y Subsidies to private house builders - House builders can be subsidised to build more houses in areas of particular shortage, including London. However, it may take many years for private house builders to find land and undertake the necessary planning, design and construction. Public house building - Central or local government can bypass the market and build more public housing. Low-cost social housing may be necessary in large cities like London given the difficulty of low paid workers getting onto the property ladder. However, the general shortage of available land limits the effectiveness of this option. Relaxing regulations - Relaxing house-building regulations, such as making planning permission easier to obtain, would act as an incentive for private house builders to enter the market. However, many regulations are essential, including those relating to health and safety, so complete deregulation is unlikely. In addition, there is a risk that such new-build housing will be marketed at the sub-prime sector, which will increase the risk of house price crashes in the future. Grants and Tax concessions - Grants or tax concessions to builders who build on brownfield sites may encourage house building on land which is less regulated.. Policies to regulate demand of housing can be outlined under the following criteria: y Altering deposit requirements - House buyers could be required to provide bigger or smaller deposits when they make their purchase. Given the general upward trend in prices, the most likely option is to require a larger deposit, which would deter the sub-prime buyer from entering the market until they had saved a sufficiently large deposit. For example, all new buyers could be forced to put down 25% of the purchase price, taking out a mortgage on the remaining 75%. On average, a first time buyer will put down just a 10% deposit, and borrow 90%. Altering interest rates - The Bank of England could raise or lower interest rates if house prices are seen to contribute the general inflation or deflation. However, the Bank of England does not directly target house prices, and will only consider changing interest rates if house price inflation or deflations are seen as central to the wider inflationary picture. Encouraging variable rate mortgages - Another policy might be to get borrowers to switch from variable mortgage interest rates to fixed long-term interest rates. In this case, repayments would be constant, and the impact of interest rate changes on the housing market, and the rest of the economy, would be greatly reduced.

One of the effects of the general upward trend of house prices is the increasing difficulty that many people have in the affordability of housing.

With average UK house prices approaching 200,000, and with average earnings around 25,000, new buyers find it almost impossible to get on the property ladder. Lenders will typically lend up to 3.5 times earnings, so an individual on average earnings of 25,000 is only able to borrow 87,500, effectively ruling them out of the housing market. Changes in affordability can be tracked with an affordability index, such as the Bank of England Affordability Index. This measures mortgage payments as a percentage of disposable earnings. High rents are clearly a deterrent to renting and may contribute to the overall housing problem, and to homelessness. In a situation of high rents, it is important to consider whether a cap on private rents would help. Rent controls are limits, imposed by central or local government, on the rent that private landlords can charge. They are a type of maximum price, and the effect can be illustrated diagrammatically.

Unfortunately, the maximum rent has created a perverse price signal which acts as a disincentive, with some landlords taking property off the market, while at the same time more people are encouraged to seek rental accommodation. The combined effect is to create a shortage of rental property. House purchases are highly dependent on the supply of mortgages from the financial system. This, in turn, depends upon the belief of lenders, the banks and building societies that borrowers will not default on their loans. When confidence is high, liquidity will flow through the financial system ensuring that funds are available. Liquidity refers to the ease with which an asset can be converted to cash. At times of rising house prices and general confidence, banks will be prepared to lend to each other to ease any local liquidity problem and make a guaranteed return. However, when confidence is low and with house prices falling lenders get wary of lending to new borrowers, many of whom will quickly experience negative equity and default on their loans, with the result that banks may stop lending to each other. As the number of new buyers starts to fall, the housing market will start to slow down even further. There are several policies that could be introduced to limit the effects of the credit crisis, and stimulate the housing market: y New liquidity could be injected into the financial system, as was attempted by the US Federal Reserve, the Bank of England, and the European Central Bank (ECB). This could be achieved by giving the banks favourable loans to improve their balance sheets, or by a process called quantitative easing - effectively printing new money. Nationalisation of failing banks, such as Northern Rock and Bradford and Bingly, or partnationalisation, as in the case of the Lloyds Banking Group and the Royal Bank of Scotland (RBS). More effective regulation of banks, especially on a global basis, as proposed at the G20 Summit in London in April 2009.

Reduce the cost of buying houses, especially for new buyers, such as by reducing the tax on house purchases, called stamp duty land tax - commonly known as stamp duty. Word Count: 4485 Bibliography and References

Ten New Propositions in UK Housing Macroeconomics: An Overview of the First Years of the Century - Geoffrey Meen - Urban Stud 2008; 45; 2759 - DOI: 10.1177/0042098008098205 House Price Determination - G Meen, University of Reading Business School, Reading, uk Do Low-Income Housing Subsidies Increase Housing Consumption? Todd Sinai and Joel Waldfogel Does the low-income housing tax credit increase the supply of housing? Stephen Malpezzi and Kerry Vandell Housing and Endogenous Long-Term Growth - Paulo M. B. Brito Housing Markets and Structural Policies in OECD Countries - Dan Andrews, Aida Caldera Snchez, and Asa Johansson Modelling Housing Market Fundamentals: Empirical Evidence of Extreme Market Conditions - Simon Stevenson Selective housing policy in local housing markets and the supply of housing - Viggo Nordvik Housing supply price elasticises revisited: Evidence from international, national, local and company data Geoffrey Meen On the use of policy to reduce housing market segmentation - Geoffrey Meen The Time-Series Behaviour of House Prices: A Transatlantic Divide? - Geoffrey Meen