House Prices and Consumer Spending in the Economy

Readers Question: in what ways can changes in house prices effect consumer spending, and hence an economy as a whole?

The Housing Market places a crucial role in determining the state of the UK economy. This is because:

  • Many consumers are also homeowners. (75% of houses are privately owned – higher than in European countries like France)
  • Houses are by far the biggest form of wealth.

What Would be the effect of falling House Prices on the UK economy?
Confidence. The value of houses plays a big role in determining homeowners outlook for the future and hence spending. If there is a fall in house prices, there is a fall in people’s wealth. Therefore, consumers will have less confidence. When house prices are falling people will be much more reluctant to start borrowing, consumption is likely to fall. The housing Market receives a lot of media attention. Even a slow down in annual house price growth can make front page headlines. Therefore, the impact of falling house prices will probably be more significant than rising house prices.

Equity Withdrawal. With falling house prices it will be more difficult to remortgage and take equity withdrawal. (Equity withdrawal is when you get a bigger mortgage against the value of your house and then spend the extra money.) Rising house prices means people can get a bigger mortgage and therefore borrow and spend more. When house prices fall this cannot occur.

Therefore, a fall in house prices will reduce consumer spending. In turn, this will lead to lower aggregate demand (AD) and therefore reduce the rate of economic growth.

There is the potential that falling house prices may cause a recession. This is because the initial fall in consumer spending may cause a negative multiplier effect.

However, it depends on how other aspects of the economy respond, lower growth will reduce inflation. This will enable the MPC to cut interest rates. Lower interest rates may enable the economy to avoid entering into recession.

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By on November 27th, 2007

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