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How can the changes in house prices which have occurred in recent years be explained?

The house prices rose sharply in the last half of 1980-s and have gradually fallen ever since. The house prices have been predicted to remain the same in 1995 as in 1994, but the long-term trend seems to be the falling price.

The prices are determined by demand and supply in free economy. The shifts in demand or supply will be followed by a change in market price. The purchase price is also inflected by inflation: all prices normally grow annually at the rate of inflation. Bigger or smaller increase will be because of some particular reason.

In housing purchases demand is inflected mostly by people's incomes, the price of other goods (mostly expensive ones, e.g., cars), population and the Government's policy of giving mortgages.

Mortgage is the long-term loan (over 10 years), which is taken out to buy a house.

As the mortgage rate was relatively low in 1980-s forming about 1/5 of total average pay, the housing market boomed. In 1970-s there were even negative real interest rates (interest rate was less than inflation) so the value of mortgages fell rapidly allowing them to buy another house (caused increase in demand).

Then the conservative government raised the mortgage rate sharply(up to 16%), average family had to pay a lot more (40% of their income). The number of repossession rose as a consequence, increasing the supply and people were more cautious when buying the house, so demand decreased.

The house-builders were faced with high and rising demand and prices in 1980-s so they started building more houses. It takes time to build a house, so in 1990 they had all finished the houses. The effect of that was an increase in supply again. This is known as a cobweb theorem and can cause the builders to stop building and the shortage might occur after a couple of years.

Also the government had a very liberal lending policy in 1980-s, that was made more strict. The tax relief on mortgage interest, especially, was lowered, so people could not afford to buy a house. This cumulative effect is shown in the graph below:

As seen, the supply and demand have shifted to S1 and D1, new equilibrium occurs at E1, with the price being substantially less that original price p. This is obviously a much exaggerated view.

 

People's incomes have risen, so they can afford to buy houses rather than just rent them. Usually 25% of the house price are paid from savings and the savings are rising. This all helps to shift demand.

The number of new houses built is a fraction of the total housing stock (0.7% of the total are built a year). The income is rising at a much faster level, so the house prices have to rise.

Inflation has been low in 1992-1994 so house prices do not have to keep up with overall rise of prices.

Local authorities were selling their houses. This decreased the price in the short run, but in the long run might cause surplus as there are no houses available for rent, so people have to buy one instead.

One very important aspect is that the crude surplus of housing over households have risen. Children are now more likely to live with parents. So there are many empty new houses. So the prices for new houses have dropped, which means more people can afford to buy one.

As the overall economy experienced a recession in 1990 due to depression in world economy, so the market activity decreased, demand fell and the house prices couldn't rise anymore. This recession affects the whole nation by multiplier effect. If people will not buy a house, then workers will have less work, their expenditure in local shops decreases, the owner of the local shop can't afford to buy a house etc.

Although I predicted that there must be a surplus in supply at present, the supply generally fell from 413700 of houses in 1968 to 319100 in 1972. This is mostly because of the public sector, where production has fallen mostly. This might have caused the initial boom in 1988 ass it takes time to built a house. In private sector after a fall in 1968 the number of houses being built have risen slowly.

The age content of population determines the demand for houses as well. If most of the people are 20-30 years old, the demand is higher, because they want a separate place to live in. This applies to opposite as well. As people are getting older generally, they do not need extra houses, so the demand is depressed again. The growth of population has fallen and will continue to fall, which again will depress the housing market.

Many people have negative equity tied to their houses (mortgage is bigger than the value of the house) that makes people unwilling to move. This reduces the supply of empty houses.

The unemployment has risen substantially making the number of mortgage arrears grow and ultimately leads to extra supply.

Although the average mortgage payments as percentages of average take-home pay were low in 1993 onwards, compared to 1980-s, the level was the same as was experienced in 1970-s. But the people are now much more in debt due to over-borrowing in 1980-s, so they are paying their debts, are unwilling to take any new debts and so will not buy a house.

The speculative effect, experienced in 1980-s where people could make thousands by buying and after a while selling a house, is lost. So the houses are now a place to live, not a sound investment.

Discuss the effect of these changes upon UK economy.

There appears to be a very close correlation between the mortgage interest rates and inflation. The problem with these statistics is that the correlation does not necessary mean causation. Mortgage interest rates might rise with inflation or vice-versa: if government raises mortgage rates, inflation follows.

One of the worst thing for the economy is rapidly changing inflation and interest rates as people can't expect it and make wrong predictions in the basis of whether to take out a loan or not. This has definitely been a case in the housing market: the price rose steeply up to 1989 and then actually fell. The mortgages are sometimes taken out for a fixed interest rate, so people who took out this fixed interest rate loan in 1990 are paying much more now. They consume fewer goods and thus through the multiplier decrease the national income. One might also argue that as this money is paid to building societies, they will invest it thus increasing the overall investment level.

The house price increases themselves are definitely causing inflation as housing costs form a major part of RPI weighting index. When house prices rose at the late 80-s inflation also rose, then when market stabilised inflation fell rapidly. Inflation is damaging the economy as people's savings in real terms are decreasing, so they have to save more reducing the consumers spending again.

Investment levels also decrease because it is riskier to invest in unstable economies. This is especially true for foreign investment, but on might argue about the real benefits of foreign investment, as the profits are drawn out of the country.

With the fall of house prices, rising costs and high interest rates, the building sector has declined. This again affects the whole economy.

Again there is a correlation with the slump in housing market and the overall recession of UK economy, but there appears to be no evidence for causation. Recession definitely caused slowdown in housing market, but the recession in housing market probably contributed towards the recession as well.

The government were forced to raise interest rates to cool down the housing market. This meant that government had to pay higher interest on the national debt. To finance it the PSBR rose (that brought inflation) and taxes had to be raised.

As construction sector declined the people working there were made unemployed. Government had to pay out more social security benefits etc. Unemployment is now a major cause for concern, but this again might have been caused by the overall recession.

The boom left many more households indebted. This reduced their overall ability to spend, so they could not afford to buy a car etc. Many individuals were forced to leave their houses and could not pay their mortgage. As the real value of the houses had fallen, banks made losses which again discouraged investment and overall confidence to UK-s economy.

During the boom people earned much money and spent it. One could earn thousands by buying a house and selling it after a couple of months. As the overall spending increased, the domestic market could not keep up with that in their sectors. So the balance of payments went into deficit. This had bad effects on the pound. The effect was magnified by overall recession and the decrease in oil-export, so UK had to leave EMS in 1992.

People's attitudes have been changed as well as many of them lost money by buying houses hoping to sell them later. This will make the firms for example less willing to invest in adventurous activities. That would constrain the overall growth in the economy.

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