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Housing market spillovers in South Africa: evidence from an estimated small open economy DSGE model

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Abstract

This paper evaluates the impact of housing market spillovers on a small open economy, namely South Africa, using a small open economy new Keynesian dynamic stochastic general equilibrium model which explicitly incorporates a housing sector. Using quarterly data covering the period of 1971:Q1–2015:Q3, we obtain the following set of results: (a) over the business cycle, the housing preference shock and the technology shock in the consumption sector drive most of the fluctuations of real house price; (b) the spillover effects of the housing market to the boarder economy are not negligible; (c) the central bank of South Africa has actively responded to house price movements over the past 45 years; and (d) the flexible exchange rate policy has helped South Africa maintain the macroeconomic stability to a large extent.

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Notes

  1. For a detailed discussion of the literature on stock market spillovers in South Africa, see Aye et al. (2015) and Paetz and Gupta (2016).

  2. We do not model explicitly an internationally traded bond, a net foreign asset position or the current account, since housing finance is mainly funded by domestic sources, i.e., 97% with the remaining 3% coming from Europeans (South African Housing Market Overview, 2016).

  3. Dividends take the following form:

    $$\begin{aligned} \hbox {DIV}_{u,t}&=\frac{X_t-1}{X_t}Y_t +\frac{X_{wc,t}-1}{X_{wc,t}}{wc}_{u,t}{nc}_{u,t}+\frac{X_{wh,t}-1}{X_{wh,t}}{wh}_{u,t}{nh}_{u,t},\\ \hbox {DIV}_{c,t}&=\frac{X_{wc,t}-1}{X_{wc,t}}{wc}_{c,t}{nc}_{c,t}+\frac{X_{wh,t}-1}{X_{wh,t}}{wh}_{c,t}{nh}_{c,t}, \end{aligned}$$

    where we assume that retail businesses are owned by unconstrained households.

  4. A detailed derivation of the Phillips curve can be found in Smets and Wouters (2003).

  5. According to the definition of openness, the optimal allocation of expenditures between domestic and imported goods is given by:

    $$\begin{aligned} C_{H,t}&=(1-\alpha )\left( \frac{P_{H,t}}{P_t}\right) ^{-\eta }C_t,\\ C_{F,t}&=\alpha \left( \frac{P_{F,t}}{P_t}\right) ^{-\eta }C_t, \end{aligned}$$

    where \(C_{H,t}\) and \(C_{F,t}\) are consumption of domestic goods and consumption of imported goods.

  6. The hypothesis that interest rate differentials are unbiased predictors of future exchange rate movements has been almost universally rejected in empirical studies. Actually, the UIP is likely to explain only a very small proportion of variation in exchange rates. In this paper, the risk premium shock explains about 30% of the variation in the exchange rate.

  7. A usual practice in the literature is to put measurement errors on wages. We add two i.i.d. measurement error shocks, \(\varepsilon _{wc,t}\) and \(\varepsilon _{wh,t}\), to the nominal wage inflation rates in the consumption and housing sectors. Both shocks have zero mean and their variances are \(\sigma _{wc}^2\) and \(\sigma _{wh}^2\), respectively.

  8. The US nominal interest rate has been around the zero lower bound since the last quarter of 2008, hence the simple Taylor rule estimation might not be accurate. However, the US economy is not of the primary interest of this paper.

  9. The main determinants of household preferences are demographics. While Iacoviello and Neri (2010) use the share of population between ages 25 and 39, we use the total population instead because there is no such a measure of population by age groups in South Africa.

  10. For detailed expositions of stock and housing market spillovers in estimated DSGE models for the small open economy of Hong Kong operating under a fixed exchange rate regime, please refer to Funke and Paetz (2013) and Funke et al. (2011), respectively.

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Acknowledgements

We would like to thank the editor Robert Kunst and two anonymous referees for many helpful comments. However, any remaining errors are solely ours.

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Authors and Affiliations

  1. Department of Economics, University of Pretoria, Pretoria, South Africa

    Rangan Gupta

  2. Department of Economics and Finance, University of Texas at El Paso, El Paso, USA

    Xiaojin Sun

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  1. Rangan Gupta
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Correspondence to Xiaojin Sun.

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Gupta, R., Sun, X. Housing market spillovers in South Africa: evidence from an estimated small open economy DSGE model. Empir Econ 58, 2309–2332 (2020). https://doi.org/10.1007/s00181-018-1613-6

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