Testing the cointegration of house and stock prices in Finland

Kari Takala and Pekka Pere
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Kari Takala: Bank of Finland
Pekka Pere: The Research Institute of the Finnish Economy

Finnish Economic Papers, 1991, vol. 4, issue 1, 33-51

Abstract: This paper looks at the efficiency of asset markets and pricing rules with regard to house and stock markets in Finland. House and stock prices are found to have unit roots, which is a necessary condition for efficient markets. However, asset prices are not pure random walks, but instead unit root processes. The unit root part is supposed to reflect the changes in fundamentals, and the error component reflects short run deviations from the market equilibrium. Evidence on cointegration between asset prices is found. Based on the hypothesis of cointegration, an error correction model is estimated. Deviations from the long run market equilibrium can be used to improve predictions of stock and house prices, e.g. house price predictions can be improved on average by using lagged changes in the stock index and the equilibrium error as a useful indicator of disequilibrium in the cointegrated markets. The presence of such an error correction term in itself shows that asset markets are not fully efficient. Granger causality between these two aggregate asset prices runs from the volatile stock market to the housing market rather than the opposite way. During the sample period the Finnish money market went through a gradual liberalization process that revealed an imbalance in the asset market caused partly by rationing in the rental housing market. In addition, tax incentives for owner occupied housing and relaxed liquidity constraints significantly increased the demand for houses during the period 1987-89. Real bank lending proved to be a significant predictor for asset prices, especially for real house prices. Error correction models with additional variables due to liquidity constraints, taxation and demand for assets were used to explain the house prices.

Date: 1991
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