The Role of Speculation in Real Estate Cycles

Abstract

Our study investigates the role of speculation in real estate cycles. We find that even a simple model of lagged supply response to price changes and speculation is sufficient to generate real estate cycles. Second, the volatility of prices – the biggest purported downside of “speculation” – is strongly related to supply conditions. Even more interestingly, the effect of speculation itself depends on supply conditions. Markets with more responsive regulatory environments, or less natural constraint (from physical geography), will experience less volatility as well as less behavior characterized as speculation. Demand conditions in general, and speculation in particular, can contribute to a boom and bust cycle in housing and real estate markets – but the effects of speculation appear to be dominated by the effect of the price elasticity of supply. In fact, the largest effects of speculation are only observed when supply is inelastic. Thus effective policies will focus on improving the efficiency of the supply of developable land, and real estate generally, including the development of an appropriate regulatory framework for real estate.

Keywords: Cycles, Speculation, Asset Pricing, Expectations