Housing market – Macroeconomy

Executive summary

The report describe the way in which changes in the housing market affect macroeconomic variables and analyzing how strong these effects are in the UK economic contest. In addition it will analyze on whether macroeconomic policy adopted in response to changes in the housing market over the last five years have been correct or not. Finally the report will give a recommendation of the right policies to adopt in the next two years in the light of current changes in the market. In UK there exist regional differences in house price this regional difference together with increase in house price has impacted on the economy through creating rigidity in labour mobility and other macroeconomic impact which include inflation, consumption, multiplier effect, balance of trade and effect on related business. The government has intervened to correct this impact through the use of interest rate, home buy scheme, use of stamp duty and other regulations. The government should therefore introduce more regulation to control mortgage lenders, use of regional reduction in stump duty to help in creating uniformity in price. Where demand for housing is high the government can relax some planning controls and introduce a new tax system where home builders are taxed differently according to regions to which they are based. The government should also employ other monetary policy tools to deal with inflation.

The main purpose of writing this report is to describe the way in which changes in the housing market affect macroeconomic variables and analyzing how strong these effects are in the UK economic contest. In addition it will analyze on whether macroeconomic policy adopted in response to changes in the housing market over the last five years have been correct or not. Finally the report will give a recommendation of the right policies to adopt in the next two years in the light of current changes in the market environment.

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Through most of the observation carried out in many countries there is a high correlation between the development in the housing sector and the business cycle. When there is a housing boom the economy experiences growth and when development in the housing sector slow down then economic growth also slows down. The deregulation of mortgage business has increased access to loan and this has been a major factor which has caused the housing boom since year 2000(iacoviello, 2005).

The UK housing market comprise accommodation in the following sectors

1. private rented
2. owner-occupied
3. local authority housing
4. housing association

Regional differences in house price exist in UK where it is more expensive to purchase a house in London and south east compared to owning a house in north, Wales, northern island and Scotland (William, 1997). This regional difference have been caused by

• Inequality of distribution of income – income is higher in south east due to economic growth and GDP.
• Differences in unemployment – due to decline in both secondary and primary industries e.g. manufacturing and mining in  places like north England this has led to high rate of unemployment and reduction in house price.
• Movement in population – there is a high number of people moving from north to London and south east (Karl, 2000). The cost of land, it availability and wages of construction workers varies according to region. Since year 2000 there have been an increase in house price and together with this regional difference the impact to the economy is in two ways

Labour mobility

People from the north and other places where houses are cheap cannot afford to live in south east and London thereby creating rigidity in mobility of labour. People in the south are also willing to move from that area and in the long run the economy may experience shortage of labour in some region which may hamper production and aggregate output in the economy. Most young people particularly graduate from college and universities cannot afford houses in some region which add to loss of human capital in this region and reduction in output (white, 1994).

Macro economic impact

Since year 2000 the housing market experienced growth of up to 20% annually in some region. This was caused by increase in real income, cost of land, low interest for mortgages, insufficient supply of new houses, speculative demand and increase in wages in construction sector. The combination of both the supply and demand factors led to shifting of demand and supply curve outward which lead to increase in house price (sawyer, 2005).

The impact of the rise in house price on the macro economy have occurred through

Inflation

Increase in house price have no direct effect on inflation as it does not form part of retail price index but as experienced in the 1980s boom where a sharp increase in house price accelerated an unsustainable consumer boom which led to an increased growth in aggregate demand. The rise in aggregate demand resulted to a demand pull inflation accompanied by a huge trade deficit (debelle, 2004).

The outward shift in aggregate demand curve is as a result of increased consumer spending which lead to a general increase in price level for good and services. Where the aggregate supply is inelastic the risk of inflation is greater as the economy cannot produce more goods to meet the growing demand(Michael, 2002).

Consumption

There is a high correlation between the price of houses and consumption levels.

This relationship has been created through the wealth effect and equity withdrawals. Housing as the greatest form of wealth in UK usually has a significant influence on confidence and expectation of consumers. Most home owner who find there wealth have increased are motivated to spend which increase the level of consumption. When the economy was experiencing recession in 1991 and house price was falling it resulted to consumer cutting their spending by 2%. The steady increase in consumer spending from 1996 to 2000 can be partly be explained by the rise in house price during the same period (Jamie, 2006).

When house price increase then it is possible for consumers to re mortgage their debt i.e. taking additional loan against the value of your home thereby increasing spending. If a person had taken a mortgage of $100,000 to build a home in 1990 and in

 year 2009 that home is worth $150,000 then the lenders allows you to borrow additional fund based on this capital gain on asset. Therefore where loan is still outstanding a person may take an additional $20,000 against the value of his house and these equity withdrawals have a significant influence on consumer spending in UK (Campbell, 2006).

With consumer spending accounting for about 66% of aggregate demand then this will cause an increase in AD and therefore boosting the economic growth. Taking the GDP equation where GDP = G + C+ I + (X-M)

Where GDP = gross domestic product

• C = household consumption
• I = private investment
• X = export
• M = import

Therefore where consumption increases it will have a direct effect on the GDP thereby increasing on per capita income and increase the rate of economic growth (Mathew, 1995).

Housing and related industries

The housing sector also supports various other sector and industries e.g. estate agent, solicitors, building, home furnishing retailers, carpet manufacturers, electrician and newspaper through advertising. Therefore when there is a boom in the housing market as that experienced from year 2000 then more of these services will be required. This in turn will result to higher employment levels, increase in aggregate demand leading to improvement in economic growth. The construction industry input into the total GDP is about 7% where the housing market is rising this industry will be forced to increase output to meet this growing demand and such increase in output will directly lead to increase in GDP therefore improving on economic growth (McLean, 1993).

Housing market and the multiplier effect

Investment in the housing sector creates income for builders and other people working in related business. The income generated improves the spending power of the local community which will increase the house price due to increased demand.

This will create a positive wealth effect to other people who will also increase consumption thereby accelerating economic growth and the whole process is what result multiplier effect.

Effect on balance of trade

High prices of houses which have the effect of increasing aggregate demand will cause more importation of goods especially luxury and with the current account deficit being 3% of GDP then increased spending can increase the deficit which would have adverse effect on the economy (harbury & lipsey, 1993).

The government has used interest rate to counter the effect of inflation. Where house price boom seem to cause inflation then the government increases the interest rate which has the effect of reducing aggregate demand thereby preventing inflation. Furthermore increase in interest rate makes mortgages expensive which reduce the demand for houses although this trend has not been observed recently. The government has intervened in the housing market through a home buy scheme. Through this scheme social workers are allowed to get an interest free loan of up to 25% of the value of their home. The government has also increased stamp duty of property above $250,000 to 3%. Those between $60,000and &250,000 by 1% and $60,000 and below do not pay any stamp duty. This has been done to decrease the demand for houses for $250,000 and above particularly in property hotspots such as London. The government has also been providing housing benefit to low income household mainly those occupying rental accommodations. These policies have played a major role in reducing the regional differences and cubing inflation pressures but still more need to be done to ensure long-run stability in the economy (McLennan, 1993).

Recommendation

As recently experienced in the US economy where the down turn in the housing market and the effect of subprime mortgages led to economic downturn destabilizing the whole economy then the government should introduce more regulation to control mortgage lenders (Karen & Donald, 2007). Furthermore the government can introduce subsidies to developer to build houses in areas with high demand. Since regional differences in house price has caused immobility of labour then the government can introduce regional reduction in stump duty to help in creating uniformity in price. Where demand for housing is high the government can relax some planning controls. Further more the government could introduce a new tax system where home builders are taxed differently according to region and use of other monetary policy tools to deal with inflation.

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