Real estate markets are driven by various factors, with housing prices

reflecting the market sensitivity to those factors. One factor affecting

housing prices is inflation. In economic terms, inflation is basically a
rise in prices. When the price to purchase a good or a service, including
mortgage loans, goes up, prices for other goods and services rise or
fall in response. Inflation, which is often an undesired economic
phenomenon, can negatively affect housing prices.
Inflation's Negative Effects
Inflation's strongest negative effect on housing prices has to do with
interest rates on borrowed money. When money becomes more
expensive to borrow due to high interest rates, people may tend not to
borrow as much of it. With high interest rates, home buyers may not
borrow any money at all or lenders may tighten lending standards.
With fewer home buyers borrowing money because of high interest
rates, fewer buyers fill a housing market, often depressing housing
prices.
Strength of Economies
In strong economies with robust growth, inflation may not have much
of a negative affect on housing prices. Strong economies make it
easier for people to afford higher prices, including interest rates,
because their incomes tend to also increase. However, stagnant or
weak economies in which income growth stagnates as well make it
more difficult to purchase housing. During weak economic growth,
home buyers might decide to delay their purchases in hopes of seeing
price declines, which often ensue.
Khc phc :
Supply and Demand Phenomenon
Build a better mousetrap and the world will beat a path to your door.
Build a super-efficient, affordable house and buyers may flock to buy it
even in weak economies and high inflationary conditions. In certain
circumstances, the supply and demand phenomenon can sometimes
overcome inflation's often-negative affect on housing prices. For
example, desirable, high-demand houses could convince people to do
whatever they can to borrow money to buy them, reversing housing
prices in the process.
Considerations
Many economists believe that a small amount of inflation is necessary
for strong economic growth. Housing prices are made up of a multitude
of inputs, including the cost of raw and finished goods, and inflation
can affect them all. Increases in interest rates can take from one to
three years to negatively affect housing prices, though. But the
relationship between interest rates and housing prices is subtle, and
there might not be a strictly linear relationship between the two.
A. The Effect of Inflation on Demand: Shortcomings of the Mortgages

Our conclusions that inflation has an unfavorable effect on the demand

for houses financed by mortgages and that fluctuations in the rate of
inflation tend to lead to corresponding fluctuations in construction
activity rests on the following considerations which are spelled out in
the rest of this section.
1. Inflation and the anticipation of its continuation tends to raise
interest rates, including mortgage rates, by an "inflation premium"
needed to compensate the lender for the anticipated erosion in the
purchasing power of his claim. The rise in interest in turn raises the
annual payment needed to acquire a house of given value.
2. This higher interest rate and resulting annual payment do not per se
change the real cost of carrying a house in that they are offset by the
gain to the debtor resulting from the gradual decline in the purchasing
power of his debt and of his annual payment.
3. Nonetheless the rise in interest rates resulting from inflation has an
important effect on the time profile of the stream of annual payments,
expressed in terms of constant purchasing power. Whereas in a world
of constant prices these payments are constant over the life of the
mortgage, the inflation-induced increase in interest rates results in an
increase in the level of real payments in the early years of the contract
with a commensurate reduction in the later years.
4.
In a world in which the households ability to meet the annual payment
is constrained by its current income (there being no significant
opportunities for second mortgages and the like) the increase in the
annual payment in the early years of the contract is bound to have an
unfavorable effect on the demand for housing by forcing many
households to postpone or forego home- ownership or scale down their
demand.
These propositions are illustrated by Table 1 and Figures 1 and 2.
Column 2 of the table shows the effect of alternative rates of inflation
on the annual payment for a $20,000 30-year mortgage. Assuming a 3
percent interest rate in the absence of inflation, the annual payment is
$1,020. As the inflation rate rises to 2, 4, and 8 percent, raising the
mortgage rate by corresponding amounts, the annual payment is seen
to increase by 30, 60, and 130 percent respectively.
The reason for the higher annual payment is that the payments are
spread over a long period of time and, in the presence of steady
inflation, these payments are made in dollars which are worth less and
less in terms of purchasing power. This proposition is illustrated in
column (3) of the Table, which expresses the annual payment in dollars
of "constant purchasing power." This column is obtained by dividing
the figures of column (2) by the price level relative to that prevailing in
the year the contract was initiated, which is implied by the assumed
rate of inflation for each of the years indicated in column (1).

In Case A, where no inflation is assumed, the figures of column (3) are

of course identical to those of column (2) with stable prices, a standard
mortgage calls for a stream of payments which is constant both in
current dollars and in terms of purchasing power.
In Case B, with a 2 percent rate of inflation, the payments of column
(3) decline at a rate of 2 percent per annum; thus while they start
higher than in Case A, they end appreciably lower, with the terminal
rate of payment only about half as high as the initial rate. This effect of
inflation in "tilting" the real stream of repayments becomes more and
more pronounced as we move to 4 and 8 percent rates of inflation in
Cases C and D. In this last case, the payments start twice as high, but
end up one-fifth as large.
This tilting effect of a rising rate of inflation on the stream of annual
payments expressed in constant purchasing power is brought out
vividly in Figure 1 which shows a graph of the real payment required in
each year of the contract (the information reported in column (3) is
only for selected years), for zero inflation, 4 percent inflation, and 8
percent inflation.
The Level of Inflation and the "Real" Cost of Housing. While the
payment streams corresponding to different rates of inflation differ
radically in shape, they do have one feature in common: the present
value of each of the payment streams measured in dollars of constant
purchasing power is the same -- $20,000 -- when discounted at the
rate of 3 percent which we have assumed represents the interest rate
which would prevail in a world of no inflation (and hence is appropriate
to dollars of constant purchasing power).
It is precisely in this sense that the higher rate of interest and the
higher initial level of money payments resulting from inflation merely
compensate the lender but do not per se increase the real overall cost
of acquiring a house. The same conclusion may be arrived at in a
different way. The cost of owning and using a house for a determined
period consists of the outlays to acquire the house less the value of the
house when sold. As long as the value of the house maintains a
reasonably close correspondence to the general price level (or better
yet exceeds it), the inflation premium paid to finance the house will be
recaptured through a eventual capital gain. In fact, taking into account
the asymetric tax treatment of interest charges (fully deductible) and
capital gains on a primary residence (totally exempt if reinvested in
another residence and taxed at the capital gain rate otherwise),
inflation should actually lower the real cost of home ownership.
The Level of Inflation and the Ability of Households to Purchase
Housing. Even though inflation does not increase the sum of
discounted payments, it will have an effect on the value of housing
which a household is able to acquire, for this depends not only on the
sum of payments but also on their time profile. The typical household
must meet payments from current income and lenders generally limit

the size of a mortgage in order to maintain a desired payment-toincome ratio in the early years of the contract. Thus, the amount of
housing which a household can acquire will be limited by its current
income and the fraction thereof it can devote to housing.
It can be seen from Table 1 that a household with an annual income of
say $10,000 and a mortgage of $20,000 could, in the absence of
inflation, service the debt throughout the life of the mortgage with 10
percent of its income; with a 2 percent inflation, the initial payment
would require over 13 percent of his income; with 4 percent inflation
nearly 16 percent; and the figure would rise to nearly 23 percent if
inflation reached 8 percent. Furthermore, as is apparent from Table 1
and Figure 1, with inflation the traditional mortgage will require higher
real payments through most of the first half of the contract than would
be required in a world of no inflation for which the mortgage
instrument was designed. Looked at from a different angle, the
traditional mortgage requires of the borrower quite different time
shapes of repayments of his "real" debt, depending on the rate of
inflation. This point is illustrated in Figure 2, which compares the
behavior over time of the unpaid balance, measured in terms of
purchasing power, for alternative rates of inflation. As one would
expect from Figure 1, a higher inflation results in a more rapid decline
in the outstanding debt. Correspondingly, the owners equity also
builds up more rapidly, if the value of the house remains constant in
real terms.
Our conclusions about the unfavorable effects of the tilting induced by
inflation are reinforced by the consideration that a major group of
potential home buyers are young households who can look forward to
an increase in income even in the absence of inflation, both because of
the general effect of productivity growth, which tends to raise all
incomes, and because typically, even in the absence of productivity
growth, income tends to rise with age, at least for a while. For such
households, the optimal time profile of real payments might be one
rising over time; inflation instead will tilt the ratio of mortgage
payments to income even further than indicated by Figure 1.2
A faster repayment schedule and the resulting higher ratio of payment
to income in the early years of the contract need not of course be a
problem for those households who had intended to save at a rate
sufficiently high to satisfy the schedule; but would be a problem for
other households and their number would grow rapidly with rising
inflation and the sulting speedup of repayments.
Even for these households, the problem could be handled in a world of
perfect markets, no money illusion, and infinite ingenuity in devising
financial instruments suited to changing circumstances. In this ideal
world, the borrowers would be able to raise otherwise the funds
needed for the high early payments, for example, through second
mortgages or unsecured personal loans. But, obviously, our world does

not meet these ideal specifications. Indeed, there is little evidence of

any significant tendency on the part of lenders to make full use even of
the flexibility in the existing mortgage contract to counteract the
higher initial payments resulting from inflation by lengthening maturity
or by raising the loan-to-value ratio. In any event, these devices would
not go very far in counteracting the effect of inflation on the early
payments.
3 On the basis of this analysis, we conclude that, under mortgage
financing, inflation is likely to affect adversely the demand for houses
by inducing potential buyers -- especially first owners -- to scale down
their demand in terms of quantity and/or quality or to forego quisition,
at least until they have accumulated enough assets for a larger
downpayment. It also follows that marked fluctuations in the actual
and anticipated rate of inflation such as have occurred in the last
decade, tend to change the demand for housing and thus contribute to
the observed swings in residential construction activity.
Uncertainty About the Level of Inflation and the Demand for Housing.
In addition to the effects just discussed, which depend on the level of
inflation, the demand for housing may also be affected by uncertainty
about the future of inflation. Consider, for instance, the case illustrated
in Case D of Table 1, when the rate of inflation anticipated over the 30
years of the contract is 8 percent, and on this basis the mortgage rate
is set at 11 percent. If the actual path of inflation turned out to be
appreciably different from 8 percent, the path of actual payments
expressed in terms of purchasing power would also be different from
that of column (3). In particular, if the deviations were prevailing in one
direction, the present value of the stream of real payments could
deviate significantly from the intended $20,000. Thus, in the presence
of significant uncertainty about the future rate of inflation, the
mortgage instrument, as a fixed long-term contract, becomes a risky
one for the borrower as well as the lender. If inflation turns out to be
higher than expected, the borrower reaps a windfall gain (and the
lender suffers a windfall loss); and if lower, the opposite occurs.
In recent history, inflation typically has turned out to be higher than
expected and, in addition, interest rates have frequently been kept
artificially low by government policy, all of which has worked out to the
advantage of the borrower. Thus there has been a tendency to assume
that inflation is detrimental to the lender, but is good for the borrower
and has a favorable impact on housing demand. Actually, once
inflation has developed for a while, and interest rates are left free to
incorporate expectations of hefty rates of inflation, anyone borrowing
on a long-term basis to invest in a house bears a substantial risk of
inflation turning out lower than anticipated.
This risk is mitigated to some extent by the prevailing early repayment
provisions on mortgages, mandated by law in many commercial banks.
Often borrowers are allowed to repay ahead of schedule with minimal

penalties. This is viewed as a social necessity to allow people to buy

and sell houses freely; but it also results in a "one-way option in which
the borrower can always get out of the original contract if interest rates
fall, thereby reducing his risk of a lower than expected rate of inflation
-- but the lender cannot get out if they rise. Of course, a rational
financial intermediary that recognizes this asymmetry should exact a
premium for this option during periods of high and uncertain inflation
and interest rates with the result that borrowers would have to pay for
the reduction of risk inherent in the prepayment clause in the form of
an even higher interest rate.
One might conclude that insofar as households are prevailingly averse
to risk, prepayment options are correctly priced, and interest rates
freely reflect expected inflation. A high and uncertain rate of inflation
could tend to reduce the demand for housing through its effect on the
expected cost and risk to the borrower. It must be acknowledged
however that, since these circumstances also increase the risk of
investment in long-term fixed-rate financial assets, they may
encourage wealth holders to invest in physical assets such as houses,
especially since much evidence suggests that equities are not a
particularly good hedge against inflation. The empirical relevance of
this phenomenon is supported by the experience of countries with high
rates of inflation.
These considerations make it hard to reach firm conclusions about the
overall impact of uncertainty about the future of inflation on the
demand for houses, especially since this depends in part on the nature
of financial instruments available to investors. One conclusion that
seems warranted, however, is that, if alternative instruments could be
devised to finance housing which reduce the price-level risk inherent in
the standard mortgage, this would also have some favorable impact at
least on the demand for owner-occupied housing. However, the
shortcomings of the mortgage arising from the uncertainty of inflation
are likely to be of secondary importance compared with those arising
from the tilting of the stream of payments discussed earlier.4
Inadequacies of Current Remedies. Several countries which at one
time or another experience double-digit inflation have come to realize
that at these high rates the traditional mortgage instrument requires
such an exorbitant initial rate of repayment of principal that it becomes
practically useless as a financing device. They have accordingly been
led to try out basic reforms in this instrument involving some form of
"price-level adjustment" along lines detailed in the reviews of Finland,
Israel and Brazil and discussed further in IV.D below. Many other
countries, including the United States and the United Kingdom have
tried to relieve the problem by holding down interest rates through
ceilings or by providing interest rate or housing subsidies. Only a few
countries, notably Sweden, have tried to combine subsidies with
financial innovation and government guarantees.

Typically, the approaches implemented or proposed in the United

States have aimed at making mortgages available to qualified
borrowers at below equilibrium interest rates. It should be apparent
from our analysis that such schemes constitute an inefficient approach:
they would be unnecessary if the right cure were provided.
If our analysis is correct, the problem does not arise from the fact that,
with a higher inflation, the borrowers can no longer afford to pay the
interest rate on the principal and amortize the debt at a reasonable
and prudent rate. Indeed, we have shown that higher interest rates
arising from inflation do not change the overall real cost of the house;
hence, inflation per se should not be a ground for subsidies, especially
to potential home purchasers who on the average do not come from
the poorest classes of society. The problem arises instead from the fact
that, with high inflation, use of the standard mortgage requires
borrowers to repay the debt at an unreasonably fast pace.
The true solution to this demand effect must therefore lie in devising
instruments such that the path of repayment of the loan (measured in
terms of purchasing power) will be independent of the rate of inflation
-- say the same as it would be under a mortgage in the absence of
inflation thus eliminating the tilt effect of the standard mortgage.