Effect of Housing Market on Economy
Q. Discuss how a boom in the Housing market affects other aspects of the economy?
A boom in the housing market involves a rapid increase in the prices of houses, for example in 2002 house prices increased by over 20%.
In the UK more than 70% of households own their own house therefore housing is a significant component of household wealth. Thus as house prices rapidly increase their will be a positive “wealth effect” as household see their wealth rise. This is likely to encourage householders to increase spending for 2 reasons. Firstly people can re-mortgage their house and engage in “equity withdrawal” This involves borrowing more money against the increased value of the house, this can then be spent. Also rising house prices are likely to increase consumer confidence and therefore consumer spending will rise.
Consumer spending is the biggest component(66%) of AD therefore the wealth effect of housing will cause AD to increase, this is likely to increase economic growth and possibly inflation as the diagram below shows.
Diagram of AD increasing
Higher growth may lead to a fall in unemployment as firms employ more workers. Also if there is more consumer spending this may adversely effect the balance of payments because consumers buy more imports, leading to a bigger deficit.
The effect of rising house prices depends upon the position of the economy, if there is spare capacity and AS is increasing then inflation is unlikely to occur. However if the economy is close to full capacity then a further rise in AD will cause inflation. (Rising house prices were a factor behind the inflationary boom of the late 1980s)
Also the effects of rising house prices depends upon other components of AD. For example in 2002 growth of AD was moderate despite a housing boom. This was because other aspects of growth were low, e.g. manufacturing output was low and the global economy was weak. Therefore the UK experienced little inflation.
In the 1980s rising house prices were accompanied by low interest rates and tax cuts, this did cause inflation.
Because house prices can cause inflation, the MPC will look at house prices, amongst other things when setting interest rates.
Rapidly rising house prices can also cause other problems, especially if the rises are concentrated in certain areas. Many important public sector workers are no longer able to afford to buy houses in areas such as London because prices are too high. Therefore hospitals and schools have struggled to attract staff.
Commentary
- It is important to recognise increased house prices cause a wealth effect and therefore higher AD.
- Many candidates say higher house prices cause a fall in demand for houses. This is wrong; it is the increased demand for houses that caused the prices to rise.
- House prices can have a significant impact on growth and inflation. However the effect isn’t certain, it depends on a few factors. Therefore it is important to evaluate the possibilities.
Copyright: Richard Pettinger 20/05/2004
