Thursday, April 26, 2007

The Effect of the Housing Market on the UK Economy

The UK housing market has a significant impact on the UK economy because:

1. 78% of households are privately owned. Home ownership rates are amongst the highest in Europe
2. Housing is the biggest form of wealth in the UK.
3. Mortgage debt accounts for the largest section of UK debt. Average mortgage debt is £21,000 per person.
4. House Prices have a significant effect on consumer confidence and expectations. (house prices and house price predictions are often front page news)

Effect of Rising House Prices.

Those who own houses will see an increase in their wealth. This is likely to increase their confidence, thereby causing higher levels of consumer spending.

In addition, if house prices rise, consumers can increase spending by remortgaging. This means they take out a bigger loan, against the value of their house. This means that the difference between, the current price and their buying price, is available for spend. Mortgage equity withdrawal has been a significant determinant of consumer spending in the UK

Higher levels of consumer spending lead to rising Aggregate Demand and therefore higher economic growth. Consumer spending accounts for 66% of AD, therefore, the effect of rising house prices can be quite significant in determining economic growth.

Higher house prices may cause inflation. This is because, if AD increases then the economy may get close to full capacity, and grow faster than the long run trend rate.

However rising house prices no not necessarily cause inflation. Firstly, it depends upon other factors affecting consumers. For example, if real wages are growing very slowly, or taxes have been increased, then consumer spending will be moderated. Since 2001, House prices in the UK have doubled, however, this has not caused inflation; the reason is that other inflationary pressures have low. For example:

  • Independent MPC target low inflation, they have raised interest rates to moderate demand where appropriate
  • Real wage growth has been low, (especially in public sector.)
  • Low global inflation - helped by cheap manufacturing imports from China, and low commodity prices.
  • Improved supply side policies increasing competitiveness of the UK economy.
  • UK manufacturing sector in recession.
  • UK economic growth close to long run trend rate.

Note: in the 1980s, rising house prices did contribute to inflation (inflation reached over 10% in 1990), because it was combined with loose monetary policy, and buoyant levels of consumer confidence.

Rising house prices are likely to cause a current account deficit. This is because rising house prices increase consumption and therefore consumers will spend more on imports from abroad. Equity withdrawal tends to be spent on luxury imported goods. The UK has a marginal propensity to import. The UK current account deficit recently increased to 3.5% of GDP.

Slump in Housing Market effect on Circular Flow

A fall in house prices will have the opposite effect. Falling house prices will reduce consumer wealth, creating a negative effect on consumer spending and consumer confidence. Therefore, there will be a fall in AD and a reduction in injections into the circular flow. This will lead to lower economic growth, unless other factors override this.

  1. Why House prices may continue to rise?
  2. How do House Prices effect Consumption

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