Federal Reserve Bank of St. Louis

In this paper we revisit the connection between changes in interest rates, loan-to-value ratios and expectations in inuencing housing prices. We construct a two good general equilibrium model in which housing is a composite good produced using structures and land. We show that changes in interest rates that are viewed as permanent have a large impact on house prices, while increases in LTV have smaller e¤ects. We also show that if the model is to account for the actual boom and bust in house prices, it must be the case that households were exposed to multiple expectations shocks. Contrary to conventional wisdom, we show that the model can reconcile the disconnectness between house values and rents, addressing an open puzzle in the literature. The authors are grateful to the stimulating discussions with Morris Davis, Dirk Krueger, Felix Kubler, Don Schlagenhauf, and the seminar participant at the 2011 Macro Workshop in Brisbane, University of Wisconsin-Madison