Consumption and housing wealth breakdown of the effect of a rise in interest rates

Abstract

In this article the effect on consumption of a fall in housing wealth and housing prices, resulting from an increase in interest rates is estimated. With the help of a dynamic multiequation, macroeconomic model, the consumer response function is broken down into two parts: a direct response related to a rise in the cost of credit and another indirect one related to the deterioration of the property market. Estimation of the theoretical model is done by means of a Vectorial Error-Correction (VEC) model.

Keywords:

• vectorial error-correction model
• wealth effect
• housing prices
• monetary policy

JEL Classification:

• C32
• C51
• E21

Acknowledgements

We thank Professors A. Cuervo, A. Garcia-Ferrer, M. Gracia, C. Montoro, J. Terceiro and J. Velarde for many helpful discussions and comments. Financial support from CUNEF and CES Cardenal Cisneros is gratefully acknowledged.

Notes

¹ A theoretical deduction of the life cycle model in a context of general equilibrium of overlapping generations can be found in Gali (1990).

² In fact, it is not necessary to assume that agents choose ∇w_t or ∇pv_t instead of w_t or pv_t . The reason for maintaining this assumption is our wish to work with a vector z_t of integrated variables of order 1, I(1), since both w_t and pv_t are I(2).

³ In the case of interest rate the small letter denotes r_t = Ln(1 + R_t ).

⁴ The evolution of the variables c_t , ∇w_t and ∇pv_t is interpreted as the result of the optimization problem of the theoretical financial accelerator models, in which private agents have to decide between two goods, to consume or buy housing, when the relative price of both goods is pv_t.

⁵ The reason for not making any assumption on the transfer function and on π_z (B) is that the proposed model allows variables not to be stationary. The data will determine whether such a polynome has unit roots or not.

⁶ It is assumed that the monetary policy of this economy is to determine the interest rate instead of money supply.

⁷ The mathematical proof can be found in Appendix 2.

⁸ The available time periods used the data for vary: consumption from 1971 to 2004, housing wealth and housing prices from 1971 to 2002 and the interest rate from 1974 to 2004. Whenever possible, the greater number of data will be used.

⁹ The data with SEC-95 methodology are available up to 1980. Previous data are provided with the growth rate of the national private consumption variable.

¹⁰ This is a monthly series, analysed by means of the geometrical mean of (1 + R_t ).

¹¹ It could also be concluded that there is a relationship of ∇pv_t with the other variables, but later analysis showed that it was the same relationship as with ∇w_t normalized in another way.

¹² The bands of confidence of the reactions at 95% are sketched in by discontinuous lines. In the Appendices 1, 2 and 3 the method used to calculate is described and the findings are presented.