Time-varying volatility and the housing market

Abstract This paper studies the role of stochastic volatility in a setting where housing serves as an important propagation mechanism. After showing time-varying volatility in US house prices, we estimate a dynamic stochastic general equilibrium model with housing, financial frictions, and stochastic volatility using a nonlinear approximation and Bayesian econometric techniques. Incorporating stochastic volatility into the model greatly improves model fit and accounts for approximately half of the increased volatility in house prices observed during the Great Recession. Increased stochastic volatility escalates uncertainty which has significant effects on macroeconomic variables. While uncertainty in most sectors has negative effects on the economy, uncertainty on collateral constraints has the largest role. Unlike other uncertainty shocks, the housing demand uncertainty creates positive spillovers in the economy. Credit conditions, adjustment costs of capital and housing, and monetary policy are important transmission mechanisms for the stochastic volatility shocks.