Household debt, house prices, and consumption in the UK: a theoretical analysis of recent developments

Fabrizio Zampolli and Matt Waldron ()

No 431, Computing in Economics and Finance 2006 from Society for Computational Economics

Abstract: Over the last two decades the United Kingdom has experienced a dramatic increase in the amount of household debt and in the level of house prices. The question which interests us is the extent to which these developments can be explained through structural changes to the UK economy. These changes include: a fall in the real interest rate; lower inflation; more competitive unsecured borrowing rates; demographic changes. It is not easy to convincingly estimate the equilibrium levels of debt and house prices empirically. For this reason our approach in this paper is to construct a quantitative, general equilibrium, endowment, overlapping-generations model. The model is sufficiently rich and incorporates: housing and non-housing consumption; tenure and landlord choices; accidental and voluntary bequests; a spread between lending and deposit rates; a spread over secured and unsecured lending; loan-to-income and loan-to-value borrowing constraints; idiosyncratic income risk; realistic demographics. House prices and rents are endogenously determined. After calibrating the model to the UK we conduct a number of experiments to gauge the contribution to the observed increases in house prices and debt of each potentially relevant structural change (in particular, lower real interest rates and financial liberalisation). We compute different stationary equilibria as well as the transitional dynamics between old and new steady states. Transitions are very long lived in our model and therefore can be potentially important in explaining the current levels of house prices and debt. Our preliminary results (so far limited to financial liberalisation) suggests that relaxation of borrowing constraints can only explain a modest fraction of the boom in house prices and debt. We also investigate the implications for aggregate consumption.

Date: 2006-07-04
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