Leir Center For Financial Bubble Research Working Paper #6

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Home Price Indices (as of March 30, 2010)

Source: http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff--p-us----

Figure 1-The Housing Bubble and Crash in the U.S.

There are also different kinds of speculators. Some of them may be more rational than others. However, it is unlikely that all or most of the speculators have rational expectations and can foresee the housing prices in the future. In fact, bounded rationality or even irrationality is not uncommon among speculators. As discussed by Baddeley (2005), “in a world of uncertainty, imperfect information, and irreversible decision-making, speculation and information acquisition will generate bubble, herding, and frenzies in housing demand.” Shiller (2009) argues that “people tend to confuse price levels with rates of price change.” He also mentions that “Karl Case and I asked random home buyers in the U.S. cities undergoing bubbles how much they think the price of their homes will rise each year on average over the next ten years. The medium answer was sometimes 10% a year.” Such bubbles “were made by widespread misunderstandings of the factors influencing prices”, or simply by the bounded rationality or irrationality of the speculators. Consistently, the Cobweb model in this research will show that it is the behavior of the speculators with bounded or adaptive rationality that causes and sustains a bubble in the housing market.

More importantly, Case and Shiller (2003) argue that “the mere fact of rapid price increase is not in itself conclusive evidence of a bubble. The basic questions that still must be answered are whether expectations of large future price increase are sustaining the market, whether these expectations are salient enough to generate anxieties among potential homebuyers, and whether there is sufficient confidence in such expectations to motivate action” (pp. 299-300). From a theoretical perspective, speculation is usually thought of as a demand side phenomenon, and the market demand is the aggregation of all the individual’s demands. One speculator with bounded rationality may not be able to raise the housing price, but large numbers of speculators with bounded rationality can cause the housing bubble to occur. Therefore, the focus of this paper is to develop a theoretical model to characterize the formation process of a housing bubble caused by the herding behaviors of speculators with bounded rationality. One important contribution of this paper is the derivation of the condition that sustains a housing bubble based on the combination of the numbers of speculators and the expected real housing price increase (adjusted by the GDP deflator or CPI).

There are four additional sections in this paper. Section 2 is a brief literature review. In Section 3, the Cobweb model is developed based on the individuals’ demand functions of non-speculators and speculators in a housing market. The combination of sufficiently large numbers speculators that enter the market and their expected future price increase not only drives up the housing price a new steady state, but also drives the non-speculators out of the market. Section 4 includes further discussions and lists some directions of extending this paper for future research. Section 5 concludes the paper.

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