Evaluation of the house price models using an ECM approach: the case of the Netherlands

The research question of this paper is whether the Dutch housing market is
overvalued or not. This is investigated by using different types of error correction
models and by examining the impact of different variables that can explain house
price changes in the Netherlands. The current financial crisis confirms the notion that
developments in the residential property sector are important for the economy as a
whole. For that reason it is important to fully understand the factors that affect the
housing market. Therefore we need a long-run model approach that relates house
prices to fundamentals. However the model should also be able to detect bubbles in
the short run. As a first step, we look at the affordability of house prices and mortgage
payments in order to check how well the housing market performs in the short run. In
the medium to long-run run, we estimate an error correction model relating prices to
fundamentals, using variables like interest rate, labour income, financial assets of
households, and household stock. The error correction model tests whether prices
tend to revert to some equilibrium price level. We evaluate existing house price
models for the Netherlands, which we use as a benchmark for comparison to our
improved model. Finally, we try to forecast housing prices based on a few simple
economic scenarios.
Keywords: Bubble, Co-integration, Error-Correction Model, Long-run Equilibrium.