THE ILLUSION OF STABILITY—LOW INFLATION IN A BUBBLE ECONOMY

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Abstract:

Econometric studies show that changes in real house prices are strongly autocorrelated in the UK, giving rise to prolonged departures from equilibrium. What happens when arbitrage is ‘broken’ and house prices no longer reflect future fundamentals? Adding a bubble to capture the disequilibrium behaviour picked up by econometricians, we show that a narrow focus on consumer price inflation—while neglecting house price disequilibrium—may for some time create the appearance of stability. But, with the bubble distorting policy and the economy on the way up and wreaking havoc on the banking system when it bursts, this is an illusion. For a bubble economy, new instruments of policy (such dynamic capital requirements and loan-to-value limits) are clearly needed—together with clear mandates as to who regulates what.

Document Type: Research Article

DOI: http://dx.doi.org/10.1111/j.1467-9957.2009.02122.x

Affiliations: Department of Economics, University of Warwick

Publication date: September 1, 2009

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