ChainWhat it assumes · how to break it
Start
UK house prices fall, as they did during the 2008 financial crisis.
1
As a result, homeowners' wealth falls, so they feel poorer and cut consumption: a negative wealth effect.
wealth effect · consumption
wealth effect · consumption
Best link to attack
Assumes: Homeowners treat housing wealth as spendable.
Assumes: Homeowners treat housing wealth as spendable.
But: Most homeowners have no plan to sell, and a lower price makes no difference to someone who will stay in the same house, so the effect on spending may be small.
2
At the same time, homeowners can borrow less against the value of their homes, so equity withdrawal falls and fewer people remortgage to fund spending.
mortgage equity withdrawal
mortgage equity withdrawal
Assumes: Households borrow against rising house prices.
But: Since tighter mortgage rules were introduced after 2008, equity withdrawal is a smaller source of spending.
3
In addition, property is the main collateral for bank lending, so as its value falls banks lend less to households and small firms.
collateral · credit conditions
collateral · credit conditions
Assumes: Banks lend less when collateral values fall.
But: If banks are well capitalised and the central bank keeps credit flowing, lending may fall only slightly.
4
Therefore, consumption and investment fall, AD shifts to the left and, through the multiplier, growth slows.
aggregate demand · multiplier
aggregate demand · multiplier
Assumes: Nothing offsets the fall in spending.
But: Lower house prices free income for renters and first-time buyers, and the central bank can cut interest rates.
End
Economic growth slows as falling house prices reduce consumption and bank lending.
Evaluation chain
- E1However, the size of the wealth effect depends on whether homeowners treat their housing wealth as spendable.
- E2Because most homeowners plan to stay in their homes and need somewhere to live wherever prices go, a lower valuation does not change the money they have to spend.
- E3As a result, the fall in consumption from the wealth effect is small for most households, and renters and first-time buyers gain from lower prices.
- E4So the main channel to growth is likely to be tighter bank lending and weaker confidence rather than the wealth effect itself, so the impact depends on how far credit dries up.
Another way to attack it: House price falls often follow rises in interest rates, so falling prices may be a symptom of tighter monetary policy rather than an independent cause. They also make homes more affordable for young buyers, whose spending on furniture and moving can rise.
Can you say this chain from memory?
Members can hide the links, test themselves and track which chains they have mastered.
Practise this chainMembers can hide the links, test themselves and track which chains they have mastered.
Questions this answers
- Assess the impact of a fall in house prices on consumption and economic growth.
- Explain the wealth effect and how it links house prices to aggregate demand.
- Discuss why falling house prices may reduce bank lending.
Diagram
AD/AS diagram: AD shifts left because consumption and investment fall; real output falls and a negative output gap may open.
Reverse and related
Rise in house prices → positive wealth effect, more equity withdrawal and easier credit, so consumption and growth rise.