The Role of Construction in the Housing Boom and Bust in Spain

This paper describes a quantitative model developed to account for the change in the level of house prices (boom-and-bust cycle) in Spain. The driving forces behind the housing boom are residential investment, immigration, current account deficits, and the elimination of land regulation. The model emphasizes the interaction of housing supply (determined by the existing stock of residential investment and new construction) with market demand. A calibrated version of the model for the Spanish economy replicates the key aggregate of the economy in 1995. The model predicts that a change in observed fundamentals can rationalize at least 84 percent of the recent boom in the value of housing capital. The model suggests that without large current account deficits and demographic changes the housing boom could have been much smaller. With respect to the housing bust, the model suggests that the combination of increasing mortgage rates, unemployment, and low productivity can have large effects in the value of housing capital. Some conservative predictions quantify adjustments that range between 24 and 29 percent.