Which Model Explains Boston Price Data?

Figure 10.5 from DiPasquale and Wheaton shows that the boom in housing prices in the1980s
follows after a sharp growth in real income. Then, the decline in housing prices in the late 1980s
and early1990s follows a decline in real income.

Forecasting Boston House Prices

The authors found that a model with backward-looking expectations fit the reality of Figure 10.5 best. (They studied the model with rational expectations and the model with exogenous expectations, but they could not explain the boom pattern in Figure 10.5.) Based on the Boston data, therefore, the authors are convinced that a model with backward-looking expectations is the best forecasting tool. To prepare a forecast, the authors were required to adopt some assumption about growth in personal income. Since the growth of income is highly uncertain, the authors adopted two scenarios on income, and their corresponding forecasts are shown below.

The first forecast assumes that the Boston economy only gradually recovers from the recession of 1989-92. Employment begins to expand at only 0.5 percent annually and personal income increases 1.0 percent annually over the decade form 1993 to 2002. Inflation is set at 3.5 percent annually; mortgage interest rates are held constant at 8.11 percent. These rates of growth are considerably below both the long-run historic growth of the Boston metropolitan area, as well as economic forecasts made in 1993.   The second forecast is based on a more optimistic scenario. The authors assume that economic growth in the Boston area returns to levels characteristic of historic expansionary periods. Job growth is assumed to be 2 percent annually, while personal income grows at 3.5 percent annually throughout the 1990s. Inflation is again set at 3.5 percent annually and mortgage interest rate at 8.11 percent. This outlook has somewhat more growth occurring than economic forecasters were predicting in 1993.

Will the Real Estate Cycle Continue Into the Future?

These forecasts make it clear that a cycle in prices and permits is likely to continue into the future. Regardless of whether you adopt pessimistic or optimistic assumptions about personal income, the Boston housing market was forecast to be headed into another period of boom and bust.