Question from Past Macroeconomics Qualifying Exam (Fall, 2005 - Question one) at George Mason UniversityEdit
Assume that there currently exists a serious house price Bubble in the US economy. What macroeconomic events might burst this bubble? Trace out the implications of such a house price bubble burst (involving significant declines in average house prices across the United States) for the US macro-economy:
- on the assumption of a non-accommodating Monetary Policy and
- on the assumption of an accommodating monetary policy.
Which of these two monetary policies would you favor, and why? Clearly outline the nature of the macroeconomic model(s) that you use.
An event leading to a burst of the bubble could include be an increase in the exchange rate which would hamper foreign investment and slow transactions in the real estate market eventually affecting prices. Another event triggering the bursting of the bubble might be an expected economic downturn, which would lead to fear of decreasing prices and would slow commercial as well as private investment.
A bursting of the housing bubble would have similar implications as the bursting of the stock market bubble had in 2000/2001. Prices of real estate would plummet due to a drop in demand. This would affect home owners by effectively lowering their wealth. Banks would increase credit requirements making it more difficult to get credit to build a new house or take out equity on the house. Companies related to real estate or construction will see their stock prices plummet and might be forced out of business. This would necessarily affect other sectors of the economy slowing growth and triggering an overal downturn.
- If monetary policy does not accomodate, i.e. to reduce the impact of the burst interest rates would tend to rise to relecting decreased investment just like other prices will also fall until a sustainable equilibrium level is reached. Many marginal companies would go out of business resulting in a clearing of the market revealing the downside of the creative destruction process as described by Schumpeter.
- If monetary policy does accomodate by lowering the interest rate and tightening the monetary base, prices would be kept from falling as much and investment would be kept at a higher level reducing the severity of the downturn. It is questionable however, whether intervention would actually reduce the magnitude of the downturn or merely slow it down and stretch the downturn over a longer period of time. (Also consider normal critiques of monetary debasement here).