Irina Issakova 2008 House Wealth Effects in Russia Thesis

FINANCIAL AND HOUSING WEALTH EFFECTS: A CASE STUDY OF RUSSIA

December 15, 2008

Irina Issakova

Undergraduate student: Department of Economics,Stanford University, Stanford, California 94305-6072 USAirina.issakova@stanford.eduAdvisor:Professor John TaylorDepartment of Economics, Stanford University

Abstract

This paper studies the effects of financial and housing wealth on consumption in the RussianFederation. It uses a newly constructed dataset of quarterly income, consumption, financialdeposits and a housing wealth measure (based on housing prices) in 74 subjects of the RussianFederation during the years 2000-2007. Previous research on housing wealth effects in Australia,the United States and across the world has been inconclusive, with some findings of astatistically significant effect of housing wealth. This paper finds a large and statisticallysignificant long-term and short-term effect of both housing wealth and financial wealth onconsumption. It finds that the housing wealth effect is larger than that of financial wealth acrosseconometric specifications.

Keywords

: housing wealth, financial wealth, wealth effects, consumptionAcknowledgments: I would like to express profound gratitude to my advisor, Professor John, forhis guidance, support and advice throughout the research process. Likewise, I am also verythankful to Professor Geoffrey Rothwell for his advice and flexibility throughout theadministrative side of this process.

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I.

Introduction

Consumption and the factors affecting it are well-studied topics in economics. Mostresearch focuses on financial short- and long-term effects of financial wealth, such as stock market wealth or wealth composed of other financial assets, upon consumption. Recently,economists have shifted attention to studying housing wealth. Housing wealth consists of theeffects of housing price changes

on households’

short- and long-term consumption.Recently, researchers have focused on the effect of a third type of wealth

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wealthderived from housing prices

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on consumption. To date, the results have been mixed, with Case

et al.

(2005), Dvornak and Kohler (2007) finding a significant and rather large housing wealtheffect on consumption, while Tan and Voss (2003) do not find a strong housing wealth effect.The economics behind studying housing wealth result from the combination of the Life-Cycle theory and the Permanent Income Hypothesis of consumption. The simple interpretationof the Life-Cycle theory is that people make rational decisions on their consumption

expenditures by “smoothing” out their incomes over their lifetimes.

Therefore, a person does notview their income as an annual salary, but as a present value of all future streams of income. If aperson expects an increase in their future income, she will upwardly adjust her consumptiontoday or within the next several periods of consumption. What follows is that increases inhousing prices should positively affect consumption because housing wealth is a possible sourceof income (e.g. through future sale of the house, possibility of taking out an equity loan, etc.).What exactly is housing wealth and how can it influence consumption? Housing wealth is

the wealth and potential spending ability that is stored in people’s homes; in other words, it is theequity in one’s house. As a house’s equity increases, so does the (hous

ing) wealth to the ownerof the house. Theoretically, the owner can spend out of his housing wealth, provided that he can

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turn it into a more liquid asset. In economies with developed mortgage markets, mechanismssuch as home equity loans can turn housing wealth into cash

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the most liquid asset. Therefore, a

shock to housing wealth can directly influence a person’s ability to spend.

Furthermore, even in an economy with a limited ability to turn housing wealth into liquidassets, increases or decreases in housing wealth can have

impacts on a households’ spending.Those effects can be purely psychological. When the price of a household’s dwelling increases

steadily for a number of periods, as was the case in Russia during 2000-2007, the household maymake the decisions to increase consumption, even if the funds do not come directly from theprice of the dwelling. This can be motivated by an anticipation of a future home equity loan or asell of the dwelling in the near future.I use quarterly subject-level data of the Russian Federation on income, housing prices andconsumption to explore the housing wealth effects on consumption. Russia is divided into 83federal subjects, which are comparable to states in other countries. Many studies of this natureuse annual, country-level data (Carroll 2004, Catte

et al.

2004, partly Case

et al.

2005) toestimate the effects of different types of wealth. Previous research has found that financial andhousing wealth tend to be highly correlated, but case Case

et al.

(2001) suggest that thiscollinearity can be reduced by using state-level data. This paper offers a more in-depth look atthe housing wealth effect, covering a considerable amount of time

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28 quarters.Section II briefly discusses the recent research on wealth effects on consumption,outlining the methods that have been used to estimate these effects. Section III describes themethodology followed in this paper, as well as dataset and how it has been constructed. SectionIV gives the descriptive statistics of the dataset and goes over the statistical results from theregressions analysis. Section V concludes the paper and provides some ideas on further study.