House Price Booms and the Current Account

A simple open economy asset pricing model can account for the house price and current account dynamics in the G7 over the years 2001-2008. The model features rational households, but assumes that households en-tertain subjective beliefs about price behavior and update these using Bayes ’ rule. The resulting beliefs dynamics considerably propagate eco-nomic shocks and crucially contribute to replicating the empirical evi-dence. Belief dynamics can temporarily delink house prices from funda-mentals, so that low interest rates can fuel a house price boom. House price booms, however, are not necessarily synchronized across countries and the model is consistent with the heterogeneous response of house prices across the G7 following the reduction in real interest rates at the beginning of the millennium. The response to interest rates depends sen-sitively on agents ’ beliefs at the time of the interest rate reduction, which in turn are a function of the country specic history prior to the year 2000. According to the model, the US house price boom could have been largely avoided, if real interest rates had decreased by less after the yea