A New Perspective on the Relationship between House Prices and Income.pdf

Electronic copy available at: /abstract=1313073 The University of New South Wales Australian School of Business Australian School of Business Research Paper No. 2008 ECON 13 A New Perspective on the Relationship Between House Prices and Income Quan Gan and Robert J. Hill This paper can be downloaded without charge from The Social Science Research Network Electronic Paper Collection: /abstract=1313073 Electronic copy available at: /abstract=1313073 A New Perspective on the Relationship Between House Prices and Income Quan Gana and Robert J. Hillb,a Draft: 16 June 2008 We show that a strong linear relationship exists between income and house price quan- tiles in Sydney (Australia), Houston, and the state of Texas. This suggests that the house price distribution is closely approximated by the income distribution after a location-scale transformation. The slope of the line changes over time in response to changes in the mortgage market. We argue that this finding is consistent with a simple variant on the permanent income hypothesis. We then explore some of the implications with regard to the evolution of house prices, price-to-income ratios, the efficiency of the housing market, the construction and interpretation of hedonic price indexes for housing, and for public policy. (JEL. C43, E01, E31, G12, R31) Keywords: Real Estate; Permanent income; Mortgage market; Housing bubble; He- donic index aSchool of Economics, University of New South Wales, Sydney 2052, Australia: q.gan@.au, r.hill@.au bDepartment of Economics, University of Graz, Universita?tsstrasse 15/F4, 8010 Graz, Austria: robert.hill@uni-graz.at Electronic copy available at: /abstract=1313073 1 Introduction House prices and price-to-income ratios have risen significantly over the last decade in many Western countries. This has led to debate over whether this rise has been caused by a bubble, particularly in the financial press [see for example Woodall (2003)