Household Debt, House Prices and Consumption in the United Kingdom: A Quantitative Theoretical Analysis

Abstract

Household debt and house prices in the United Kingdom rose substantially between 1987 and 2006. In this paper we use a calibrated overlapping generations model of the household sector to examine the extent to which changes in demographics, lower inflation, and a lower long-run real interest rate may explain the build-up of debt and the rise in house prices over that period. Our model suggests that lower real interest rates were particularly important. If households expected lower real interest rates to persist, then the model can more than explain the rise in debt and can explain most of the rise in house prices. However, the model leaves a puzzle because it predicts that an unanticipated fall in real interest rates should lead to a consumption boom that did not materialise in the data.

Keywords: Consumption, housing market, collateral constraints, life cycle, OLG

JEL Classification: E21, R31