Assessing the role of income and interest rates in determining house prices

Property prices across many OECD countries have witnessed remarkable increases over the past 10 years. Two factors frequently posited for this boom are higher income levels and the benign interest rate environment experienced in many of these countries. However, empirical models of house prices struggle to achieve credible results concerning the impact of interest rates with coefficients that are frequently insignificant or of the wrong sign. In this paper we propose an intuitive theoretical model of house prices where the demand for housing is driven by how much individuals can borrow from financial institutions. This level of borrowing depends on disposable income levels and current interest rates. We empirically test this model by applying it to the Irish property market. Our results support the existence of a long-run relationship between actual house prices and the amount individuals can borrow with plausible and statistically significant adjustment to this long run equilibrium. (C) 2007 Elsevier B.V. All rights reserved.