Let us now investigate the interplay between models and data by means of a couple of examples.
The first simple economic model we proposed related house prices and mortgage rates. That model argued that an important cause of the recently observed rise in house prices was the decline in mortgage interest rates. Figure 2.1 illustrated that relationship with a diagram and Equation 2.1 put the model in terms of basic algebra.
The logic of the model is based on the effects of the costs of financing on prices and specifically on house prices. Lower mortgage rates make financing house purchases more affordable and lower the income criteria that mortgage lenders apply to mortgage approvals. Potential buyers can afford higher priced houses and potential sellers may expect to get more for their properties. As a result, our model argues that lower mortgage rates push up house prices.
There is also an important policy issue here. On several occasions the federal government minister of finance has expresses concerns about low mortgage rates and long mortgage terms as a potential cause of a house price ‘bubble’. Experience with house price increases in other countries leading up to the financial crisis of 2008 provides a solid basis for this concern. As a result starting in 2008 and as recently as 2012 the federal government has taken action to discourage competitive reductions in mortgage rates, to limit the terms and amortization periods and to increase down payment requirements for new mortgage. The underlying rationale for these actions is the belief that higher mortgage rates, shorter terms and higher down payments will relieve upward pressure on house prices.
Let us now formalize the above ideas into an economic model of house prices. Several factors influence house prices and mortgage rates are one; another is the income of the potential buyers; a third is the number of houses or condominiums that come on the market – either new or not; a fourth could be the growth in population in the area where we are exploring house prices. If we think these are the main determinants of house prices then we could formalize this theory in the following model:
House prices = f (mortgage rate, incomes, supply of housing offered on the market, population growth;...)
The notation f (...) means that the variable on the left-hand side of the equation is a function of the variables inside the parentheses. This equation is, therefore, an economic model that links behaviour to its main determinants.
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