Research Discussion Paper – RDP 2018-04 DSGE Reno: Adding a Housing Block to a Small Open Economy Model

We propose a straightforward approach to adding a housing sector to a large-scale open economy dynamic stochastic general equilibrium model. The model has four intermediate sectors: non-traded, housing, traded, and resources. Households are assumed to consume housing services as part of their consumption bundle and gain utility from holding housing stock. The utility specification increases households' willingness to hold housing stock and implies a relatively high sensitivity of housing investment to monetary policy. We estimate the model on Australian data and find that our model is better able to match a number of empirical regularities compared to a model without housing. These regularities include the sensitivity of housing investment to interest rates and the persistence of aggregate output's response to monetary policy shocks. We then use the model to explore the role of the housing sector in the rebalancing of the Australian economy following the end of the mining boom. First, we find that most of the recent increase in housing investment has been an endogenous response to the large fall in commodity prices and associated declines in interest rates. Second, the pick-up in housing investment has significantly supported the economy over the past five years, adding a ½ percentage point to GDP growth and a ¼ percentage point to inflation, in year-ended terms.