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BA 280/BA E-280
Final Exam Solutions
Spring 1998
Part I
a. Real interest rates tend to rise during inflationary periods, causing real estate to be a good
hedge against inflation -- this statement should be sub-divided into two parts. First, real
interest rates do not tend to rise during inflationary periods. In fact, since nominal rates are
less volatile than changes in expected inflation, real rates tend to fall during periods of
changing increasing inflation, and tend to fall in periods of declining expected inflation. That
is, the Fisher equation which assumes that real rates stay constant, and nominal interest
rates move point for point with changes in expected inflation are probably not correct. In
addition, changing inflation rates probably lead to increased economic uncertainty, which in
tern may cause ceteris paribas for real rates to increase. These facts cause the real rate not
to be constant. In addition, one might explain that real rates and expected inflation changes
are impacted by a combination of savings income and wealth effects, lender/borrower effects
through the tax system, as well as the capital allowance (depreciation tax) effects on real
rates of return and investment. For the latter analyses examine the article by Taylor.
Second, real estate may or may not be a good hedge against inflation. Unanticipated
inflation in hot (i.e. excess demand relative supply) real estate markets tend to outstrip in
terms of rate of return or value changes in general inflation. This is caused by the fact that
unanticipated increases in expected inflation tend to cut off real construction activity in real
estate. Thereby exacerbating excess demand for real estate, causing real rent increases,
declining real vacancy rates, as well as the overlay of general inflation. In cool markets, the
impact of the construction decline will be minimal, causing the imbalance between supply and
demand to be minimal, thereby in turn having little or no impact upon existing real estate.
The key point is that generally unexpected inflation will stimy at least for the short run,
construction, which will tend to increase values very quickly in hot real estate markets; and
have little or no impact on existing real estate in cool markets.
b. The residential construction cycle strongly influenced by monetary policy. Residential
construction cycle is in theory caused by the residual user hypothesis. The residual user
hypothesis indicates that residential construction cannot compete for resources with other
sectors. Therefore, when the economy is booming, the residual of resources available for
residential use declines, and vice versa, when the real economy is at a low point in the
economic cycle, one would anticipate that there are larger residuals of resources available for
the residential sector construction. If this theory is correct, then residential construction
should be fundamentally counter cyclical.
One of the resources used by builders is credit (i.e. builders tend to be highly levered in their
activities). Because of this, and the fact that over the cycle monetary policy tends to "lean
against the wind," the total availability of credit tends to be counter cyclical. Therefore,
monetary policy usually works against residential construction to intensify its counter cyclical
nature. One also might discuss why the residential sector cannot compete for resources, and
why the residual user hypothesis is reasonable.
Graph I
c.
Increased housing market efficiency is the ultimate solution to housing the poor. This
theory suggests that the housing market is efficient and that housing the poor is not a
problem of the marketplace. If you do not like the allocation of housing to various
households, then there is an income problem. If you increase household income, in
general, you would be able to the quality of housing that household's live in. See graph II
for the Lowry efficient market argument.
Others argue that the housing market is inefficient in the allocation of resources. In
particular, because of externality effects, profitability bias, and social costs, (all of these
can be explained in more detail) one would expect that the market will allocate housing in
a sub-optimal way. That is, housing values, and the real amount of housing produced
and consumed will not produce the highest and best use in a market context (e.g. slums).
To solve this problem one needs to internalize the externalities or create regulation of
housing markets in order that externalities do not have a negative impact upon
production and consumption of housing.
You might also discuss that the removal of low quality housing (i.e. slum housing) will
only reduce the supply of housing available to the poor, thereby, increasing their cost of
housing vis-à-vis other sub-sectors of the income distribution. You might also discuss the
______________ dilimna analysis of slumlords. In essence, one would argue that
market efficiency is not the solution to housing the poor, neither if you are a marketer for
housing a externalities theorist.