The equation: How falling house prices affect consumer spending

February 26, 2016

From: Magazine

Many economists used to think that changes in house prices had little effect on consumption, but data from the 2007–10 financial crisis and the slow recovery that followed are changing that view. Economic theory is now catching up to help explain the large link observed between plunging house prices and deep spending cutbacks.

Northwestern’s David Berger and Guido Lorenzoni and Chicago Booth’s Veronica Guerrieri and Joseph S. Vavra propose that consumption’s response to a change in house prices can be measured by looking at two variables: an individual’s marginal propensity to consume (MPC) as a result of temporary income changes (say, a salary bonus) and the value of her home. High-debt, low-net-worth individuals typically have a high MPC, so a negative shock to home prices, especially at the peak of the housing market, would have a large negative effect on their spending.