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Unit 8 Economic dynamics: Financial and environmental crises

8.6 Structural changes in the housing market and shifts of the S-shaped PDC

Figure 8.14 shows that, with an S-shaped PDC, a sufficiently large price shock in the housing market can produce a change in current prices past the tipping point, resulting in a boom or a bust in housing prices (depending on whether the initial equilibrium was high-price or low-price). So the model could explain the booms and busts in house prices similar to those shown in Figure 8.8.

Unlike housing, large jumps in prices are observed for the prices of shares and assets such as Bitcoin.

But historically, house price booms have not been initiated or ended by a dramatic one-year change in the price of housing. In this section, we extend the model to include shifts in the PDC itself to better match the price dynamics that can trigger a boom or bust. For an economy at the high-price equilibrium, a shift of the PDC can eliminate the tipping point and the resulting familiar price dynamics take the market to the lower-price equilibrium (in the case of a bust).

So far, we have considered booms or busts as reactions to a shock—meaning some change in the price today that is the result of causes outside the model, without any changes in the model (the PDC remaining unchanged). By a ‘shift’, we mean a movement of the curve itself, that is a change in the PDC itself.

Therefore, there are two things that might disrupt an equilibrium:

  • Shocks (movement along a PDC) occur when there is a change in this period’s price happening for reasons outside the model (such as a shift in the demand curve due to the launch of a new property website technology) that then affects next period’s price (as captured in the name of the curve: price dynamics).
  • Shifts (movement of the whole PDC) occur when there is a change in beliefs about future house prices for reasons other than a change in the price itself (such as concern that the current level of prices at a high-price equilibrium is too high given household incomes and credit conditions).

Explaining shifts of the price dynamics curve in the housing market

Why would the PDC shift? Remember that the PDC tells us how the price that will occur next year depends on the price this year; but the price of housing next year will be affected by things other than the price this year. It depends, among other things, on what people expect to happen to house prices in the future.

Now suppose that at the high-price equilibrium some people ‘get cold feet’. They think prices are far too high given housing affordability (the demand side) and the supply of houses. In England and Wales, for example, the index for house prices went up almost threefold between 1998 and 2008, while the index of earnings increased by only one-half. If you think about how many more years of earnings would be needed to buy a house in 2008 than a decade earlier, the drastic fall in the affordability of housing is clear.

‘These high prices can never last,’ they say to themselves. They begin to think that house prices will fall: “It’s time to sell so that when prices fall, I can get a better house for the same money or I can use my capital gain to go up-market.” Owners with a mortgage start to worry that lower house prices could leave them in a situation in which the market value of the house is less than the mortgage they owe to the bank. They want to sell before the price falls to reduce the risk of falling into this situation of negative equity.

As selling housing rather than buying it begins to look like the best way to make capital gains, the pessimistic expectations become self-fulfilling: prices fall.

Shifts of the price dynamics curve

Suppose the housing market is initially at point D in Figure 8.15. At G, the expected price next period is the same as in the current period as it is one point where the PDC intersects the 45-degree line. Now suppose—due to people coming to believe that the high prices cannot last—that the expected price next period is lower than the price this period. This will be a point on a new PDC vertically below D. The entire PDC shifts down and is shown by the dashed line, PDC′. The market moves to a new equilibrium at D′, and there is a new tipping point at T′.

The diagram illustrates the dynamics of price adjustments over time. The horizontal axis displays the price in period t, denoted as P_t, and the vertical axis shows the price in period t+1, denoted as P_{t+1}. The coordinates are (price in period t, price in period t+1). A 45-degree upward-sloping straight line from the origin is labeled ‘price unchanged from year to year’. An upward-sloping, S-shaped line labeled PDC intersects this 45-degree line at three points: C, T, and D. Point C, at a lower price level, represents a stable equilibrium at a low price. Point T, at a middle price level, represents an unstable equilibrium. Point D, at a higher price level, represents a stable equilibrium at a high price. Another upward-sloping, S-shaped line positioned beneath the original PDC is labeled PDC′. This line intersects the 45-degree line at three points: C′, T′, and D′. These intersections are located beneath the original intersections, C, T, and D, and are labeled as the new stable equilibrium at a low price, new tipping point, and new stable equilibrium at a high price, respectively.
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https://www.core-econ.org/macroeconomics/08-financial-environmental-crises-06-housing-market-changes-pdc-shifts.html#figure-8-15

Figure 8.15 A shift in the S-shaped PDC.

The shift of the PDC has brought the market closer to the tipping point and the danger of a collapse of the house price boom.

However, the ‘new normal’ at point D′ may not last. Confidence may re-emerge that housing is a good bet and that prices next period will be higher than they are at point D′—if so, the PDC could shift up to its initial position and the stable equilibrium at the higher price shown by point D be established once again.

This is not the only possibility. If the view takes hold that the price at point D′ is not too low but is still ‘too high’, given affordability, for example, then the structural shift of the PDC is downward—for example, to PDC″ in Figure 8.16. In this case, the equilibrium at point T′ cannot last. Once sentiment in the housing market has shifted sufficiently that the S-shaped curve (dotted) is below the 45-degree line (except where the price is very low), there is only one equilibrium in the market and it collapses to point C″.

There are two diagrams. In the first diagram, the horizontal axis displays the price in period t, denoted as P_t, and the vertical axis shows the price in period t+1, denoted as P_{t+1}. The coordinates are (price in period t, price in period t+1). A 45-degree upward-sloping straight line from the origin is labeled ‘price unchanged from year to year’. Three upward-sloping, S-shaped lines labeled PDC, PDC′, and PDC′′ intersect this 45-degree line, with PDC positioned at the top, PDC′ in the middle and PDC′′ at the bottom. The line labeled PDC′ intersects at point D′ while line labeled PDC′′ intersects at points C′′ and D′′. The points C′′ represents stable equilibria at low prices, while points D′ and D′′ represent stable equilibria at high prices. Notably, the line PDC′′ does not intersect the 45-degree line in the middle, indicating that there are no tipping points. The second diagram is almost the same as the first one, but it includes additional red arrows to represent the price adjustment process. These arrows positioned in the space between the 45-degree line and PDC′′ illustrate the movement from D′ to D′′, and then continue towards C′′.
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https://www.core-econ.org/macroeconomics/08-financial-environmental-crises-06-housing-market-changes-pdc-shifts.html#figure-8-16

Figure 8.16 A shift in the PDC eliminates the tipping point from three equilibria to one.

This model helps to explain the fear that a bubble in an asset market can be followed by a crash with serious ramifications for the economy.

Question 8.5 Choose the correct answer(s)

Figure 8.16 shows some S-shaped price dynamics curves for the housing market. Based on the figure, read the following statements and choose the correct option(s).

  • There can be 1, 2, or 3 equilibria in the housing market.
  • Points T and D represent unstable equilibria.
  • A positive feedback process means that housing prices are always increasing.
  • Optimism about housing prices would shift the PDC upwards.
  • The S-shaped PDC can intersect the 45-degree line 1 to 3 times, as shown in Figures 8.15 and 8.16.
  • Point T is an unstable equilibrium, but point D is a stable equilibrium.
  • A positive feedback process could result in housing prices decreasing. For example, on the curve PDC, a negative shock at point T would cause housing prices to decrease until the intersection between PDC and the 45-degree line.
  • Optimism would result in higher prices for both of the stable equilibria (the opposite of what the figure shows).

Exercise 8.4 A boom in the housing market

Present a set of five figures describing how structural shifts in the housing market can create a house price bubble. Use the following captions for your figures. You need to provide an ‘explanation’ as well as a diagram for each slide.

  • Figure 1: Low and stable prices
  • Figure 2: Some owners become more confident about the market
  • Figure 3: A structural shift in the housing market results in higher but stable prices
  • Figure 4: The tipping point disappears
  • Figure 5: Prices boom

Exercise 8.5 The big ten asset price bubbles of the last 400 years

According to Charles Kindleberger, an economic historian, asset price bubbles have occurred across a wide variety of countries and time periods. The bubbles of the last 100 years have predominantly been focused on real estate, stocks, and foreign investment.1

  • 1636: The Dutch tulip bubble
  • 1720: The South Sea Company
  • 1720: The Mississippi Scheme
  • 1927–1929: The 1920s stock price bubble
  • 1970s: The surge in loans to Mexico and other developing economies
  • 1985–1989: The Japanese bubble in real estate and stocks
  • 1985–1989: The bubble in real estate and stocks in Finland, Norway, and Sweden
  • 1990s: The bubble in real estate and stocks in Thailand, Malaysia, Indonesia, and several other Asian countries between 1992 and 1997, and the surge in foreign investment in Mexico 1990–1999
  • 1995–2000: The bubble in over-the-counter stocks in the US
  • 2002–2007: The bubble in real estate in the US, Britain, Spain, Ireland, and Iceland.

Pick one of these asset price bubbles or a bubble in a digital currency. Find out more about it, and then tell the story of this bubble using the models in this section.

  1. Charles P. Kindleberger, and Robert Z. Aliber. 2005. Manias, Panics, and Crashes: A History of Financial Crises (Wiley Investment Classics). Hoboken, NJ: Wiley, John & Sons. ↩