Unifying empirical and theoretical models of housing supply

Housing supply plays an important role in the volatility of macroeconomic cycles and the speed with which house prices respond to changes in demand, yet it is understudied in the current literature. In this paper we present and estimate a new model of the supply of residential construction that is consistent with the theoretical treatment of land development and urban growth. This model shows that new housing construction is best described as a function of changes in house prices and costs rather than as a function of the levels of those variables. Previous research that uses the price levels specification has the drawback that a one-time increase in the number of households that raises the level of real house prices leads to a permanent jump in new construction and thus an infinite increase in the stock of housing. The empirical tests of the model support our new specification, which performs better than alternative models in out-of-sample forecasts. Our estimates suggest a fairly moderate response of supply to house price changes. A 10 percent rise in real house prices leads to an 0.8 percent increase in the housing stock, which is accompanied by a temporary 180 percent increase in the average number of quarterly starts, spread over four quarters.