How house prices can affect the Whole Economy.

House Prices have a significant impact on the National Economy

• House prices are the biggest component of household wealth.
• The number of homeowners in the UK has increased with a bigger % of people buying their house rather than renting.
  
• This trend has been helped by the sale of council houses in the 1980s.
  
• It was Mrs Thatcher’s desire to transform the UK into a property owning democracy. To a large extent this has been done. (78% houses are owned)

Rising house prices increase consumer wealth and are likely to be associated with an increase in mortgage equity withdrawal.
means people remortgage and take out a bigger loan against the value of their house. It means they have more money that they can spend and this leads to an increase in consumer spending and therefore Aggregate demand.

Rising house prices can also increase consumer confidence. It encourages people to take out other borrowings as they know that they can always release equity from the value of their house if necessary.

Therefore rising house prices can be instrumental in raising consumer spending and economic growth. Rising house prices can also be inflationary. This will occur if increasing house prices cause economic growth to be unsustainable. For example in the late 1980s rising house prices were a key factor in causing the inflationary Lawson boom of 1989. However rising house prices do not always cause inflation. If other components of economic growth are increasing at a slow rate, house prices may not cause inflation. For example between 2001-2007 house prices in the UK have been rising far quicker than the rate of inflation (which has remained in governments target of 1-3%)

Effect of Falling House Prices

Falling house prices usually have a more powerful effect than rising house prices.

People are used to rising house prices and the majority of homeowners don’t actually release the increased equity through remortgaging. However when house prices fall it can trigger a large fall in consumer confidence. People view falling house prices as a serious problem and in the past has been associated with reductions in consumer spending as people become much more risk averse.

For those who have recently remortgaged or bought a house falling house prices can lead to negative equity. Negative equity means the value of the house is less than the outstanding mortgage debt. This is a real problem for those who are struggling to meet mortgage repayments; there is no option to switch mortgage deals and reduce monthly payments.

Again the effect of falling house prices depends upon other variables in the economy.

For example falling house prices in 1991 was associated with a period of very high interest rates. Therefore homeowners were faced with a twin problem of high mortgage costs and falling house prices. If house prices fell in the UK in 2007 or 2008 real interest rates would likely be much lower. Furthermore the MPC would be likely to cut interest rates as falling house prices reduced inflationary pressures.

See also How House Prices affect economic growth and inflation in UK

See also Role of House Prices in determining Monetary policy

Effect of the UK Housing Market on the rest of the UK economy

The UK housing market can have a big impact upon the UK economy. With rising house prices there is a corresponding rise in the wealth of homeowners.

1. Firstly house prices are the biggest form of wealth in the UK. If house prices rise, then it has a significant impact upon consumer wealth.

2. If house prices rise it can lead to increased consumer spending for 2 reasons. Firstly increased house prices will lead to a rise in consumer confidence. As people feel more “wealthy” they have more confidence to spend. Secondly people can remortgage their house to take out equity from their house. This gives them more money to spend.

3. Therefore rising house prices lead to an increase in consumer spending. As consumer spending is the biggest component of Aggregate Demand (66%) higher house prices lead indirectly to increased rates of economic growth.

4. However it is worth bearing in mind that rising house prices, do not necessarily lead to higher growth rates, it depends upon what else is effecting economic growth, such as taxes and government spending.

5. Rising house prices can lead to inflation. If the increase in house prices causes a rise in consumer spending then it could cause inflation, especially if the economy is close to full capacity. For example in the late 1980s the UK economy witnessed very fast rises in house prices and this was a major contribution to the rampant inflation of the late 80s boom.

6. Higher house prices can lead to increased interest rates. Interest rates are set by the bank of England. There primary target of monetary policy is to keep inflation at 2% CPI +/-1 A rise in house prices doesn’t automatically cause interest rates to rise, but if the bank feel that increased house prices will feed through into higher inflation then they will raise interest rates to pre-emptively stop inflation.

7. Regional variations in house prices can affect local economies. For example very high house prices in London can cause a shortage of skilled labour like teachers and policemen. This is because it is too expensive to be able to buy houses in the UK.

More on UK Housing Market