Discussion paper
DP14120 Learning from House Prices: Amplification and Business Fluctuations
We provide a new theory of demand-driven business cycles based on learning from prices in an otherwise frictionless real model. In our model, house price increases caused by aggregate disturbances may be misinterpreted as a signal of improved local consumption prospects, leading households to demand more current consumption and housing. Higher demand reinforces the initial price increase in an amplification loop that drives comovement in output, labor, residential investment, and house prices even in response to aggregate supply shocks. The model's qualitative implications are consistent with observed business cycles, and it can explain apparently autonomous changes in sentiment without resorting to non-fundamental shocks.
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