Aggregate Uncertainty, Individual Uncertainty and Illiquidity: Housing and the Business Cycle.Indiana University, mimeo

In the post World War II period for the United States, housing investment has lead out-put by one to two quarters. At the same time, housing prices are procyclical. These two observations imply that a demand shock for housing leads the business cycle. This paper tests one possible mechanism that can generate such shifts in the demand for housing. The particular mechanism in question is composed of three parts: (1) a transaction cost in the housing market, such as broker fees, closing costs, etc; (2) uninsurable shocks to individual earnings; and (3) the uncertainty of shocks to individual earnings is countercyclical. These three components make a potential homebuyer reluctant to buy a home at the start of a reces-sion due to the greater likelihood of a bad earnings shock causing him or her to have to re-sell a home just purchased at a substantial loss due to the transaction cost. On the other hand, a potential homebuyer would be quite willing to buy at the start of an expansion. The results of a model calibrated to the post World War II United States show that at constant interest rates, the median homebuyer buys a home with a down payment of 12.9 % in expansions, and 17.8 % in recessions. These results generate large increases (decreases) in housing demand at the start of an expansion (recession) that help explain the leading behavior of housing invest-ment. Furthermore, the results suggest that if there are imperfections in asset markets then the presence of uninsurable individual earnings can have a signiÞcant impact on the business cycle