An Extrapolative Model of House Price Dynamics∗

A model in which homebuyers make a modest approximation leads house prices to display three features present in the data but usually missing from perfectly rational models: mo-mentum at one-year horizons, mean reversion at five-year horizons, and excess longer-term volatility relative to fundamentals. Valuing a house involves forecasting the current and fu-ture demand to live in the surrounding area. Buyers forecast using past transaction prices. Approximating buyers assume that past prices reflect only contemporaneous demand, just like professional economists who use trends in housing prices to infer trends in housing demand. Consistent with survey evidence, this approximation leads buyers to expect increases in the market value of their homes after recent house price increases, to fail to anticipate the price busts that follow booms, and to be overconfident about the accuracy of their assessments of the housing market