Rising house prices increase consumer wealth and are likely to be associated with an increase in mortgage equity withdrawal. 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%)
Affect 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.