The RBA's housing market model explained

The RBA's housing market model explained
The RBA's housing market model explained

RBA economist Trent Saunders and RBA senior research manager Peter Tulip have created a model to summarize the Australian housing market.

"We build an empirical model of the Australian housing market that quantifies interrelationships between construction, vacancies, rents and prices," Saunders and Tulip said.

"We find that low interest rates (partly reflecting lower world long-term rates) explain much of the rapid growth in housing prices and construction over the past few years," the paid said.

"Another demand factor, high immigration, also helps explain the tight housing market and rapid growth in rents in the late 2000s.

"A large part of the effect of interest rates on dwelling investment, and hence GDP, works through housing prices.

Click here to enlarge the key model relationships in the Australian housing market.

The RBA's housing market model explained

The model has six important equations, denoted by blue boxes.

"It also contains a large number of identities and simple forecasting equations (typically autoregressions) used for projecting forward variables we think of as exogenous," Saunders and Tulip said.

A brief discussion of each of the key points, highlighted by Saunders and Tulip, are found below. To read the full RBA release, click here.

Building Approvals

"We model constant price building approvals for detached houses, higher-density housing, and alterations and additions separately.

"This disaggregation is useful because the different types of construction behave differently and because alterations and additions do not contribute to the number of new dwellings, an important factor in explaining the vacancy rate."

Dwelling investment and the housing stock (constant prices)

"Dwelling investment is a volatile component of GDP and is important for macroeconomic forecasting and policy.

"It has also been a focus of other researchers and model builders, so our predictions for it facilitate comparisons.

"Approvals flow into dwelling investment with a long-run elasticity of 1.

"Specifically, for each category of housing construction, we map approvals through to commencements, then commencements to work done, work done to dwelling investment, and finally, dwelling investment to the constant price measure of the housing stock.

Completions and the number of dwellings

"The second chain of variables affected by dwelling approvals explains the number (as distinct from the value or volume) of dwellings that are built.

"To estimate the number of approvals we remove alterations and additions and the effect of the changes in quality (most evident in larger floor sizes) from the estimates of new dwelling approvals."

Rental Vacancies

"Figure eight (below) shows components of what might be considered as ‘excess supply’ of housing.

"The green line in the top panel shows quarterly changes in the number of dwellings. This equals housing completions (as modelled in the previous section) less demolitions.

"This is often called the supply of new dwellings, though the demand/supply distinction is difficult to apply to owner-occupied housing, which households provide to themselves.

The RBA's housing market model explained

"These estimates are lower than the ‘housing supply’ estimates of Ong et al because we allow for both approvals that are not completed and demolitions.

"The purple line shows what we call ‘underlying’ household formation, defined as quarterly changes in adult population, which is an important and exogenous component of underlying demand, divided by a five-year trailing average of adults per dwelling."

Housing Prices

"Research on the determinants of housing prices, both in Australia and overseas commonly focuses on the user cost of housing.

The user cost represents the annual cost of owning a house, comprising the sum of interest payments, repairs, rates and other running costs, less expected capital appreciation.

"In the long run, this tends to be close to the cost of renting a similar dwelling.

"If the user cost were lower than rents, households would be financially better off owning than renting and might be expected to bid up the price of houses.

"Conversely, when renting is cheaper, there would be downward pressure on housing prices."

To read the full RBA release, click here.

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