Tuesday, July 12, 2011

A Simple Cobweb Model of Speculative Housing Bubbles

[Author: P. Ben Chou, New Jersey Institute of Technology]

This research develops a simple Cobweb model that characterizes how a housing bubble forms and bursts. In particular, the model shows that the combination of the entry of a sufficiently large number of speculators and their expected price increase can reinforce each other and sustain a housing bubble at a new steady state in the short run as a self-fulfilling prophecy. The entry of speculators can also lower the fluctuations of the housing price, while the exit of the speculators will increase the volatility of the housing price. After the bubble bursts, it will be the re-entry of non-speculators that stabilizes the housing price. However the time frame for re-entry may be lengthy because potential homebuyers may be expecting price to fall even further. In addition, if banks are reluctant to begin lending again, government support as a lender of last resort may be required to speed up the process.

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