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Michel Camdessus Michel Camdessus Central Banking Lecture

Janet Yellen, Chair of the Federal Reserve Board, delivered the inaugural lecture. The new lecture series will become an annual event, which is intended to highlight the IMF’s commitment to collaboration with member countries’ central banks and provide a forum to discuss topical issues in central banking.

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Interest Rates and Fundamental Fluctuations in Home Values

Albert Saiz

Massachusetts Institute of Technology



Fluctuations in housing prices are relevant to wealth accumulation, labor mobility, consumption, macroeconomic volatility, and financial market stability. However, it is ex ante difficult to know when housing price movements are due to fundamentals, such as changes in the user cost of capital, versus irrational exuberance. I propose combining the canonical urban economics Alonso-Muth-Mills model and Poterba (1984, 1990) housing asset-pricing equation to form grounded theoretical expectations about the impact of changes in the user cost of capital on home values. I show rental prices and rental expenditures to be endogenous to interest rates, which limits the applicability of conventional price-to-rent ratios. Expected changes in home values can be expressed as simple functions of the supply elasticity of housing, and the initial share of land relative to prices in a city. The simple formula can be used to diagnose and underwrite home valuations under the null hypothesis of a common shock to the user cost of capital. Empirically, I find that housing supply elasticities and land shares as of 1990 predicted 50% of the variance in price growth during the past boom. Deviations from theoretical growth mean-reverted dramatically during the bust period.