Question

An article in the Wall Street Journal on the housing market stated, "Steady job growth, rising wages and low interest rates have helped prop up housing demand." Why do low interest rates increase the demand for housing? In which component of aggregate expenditure does the Bureau of Economic Analysis include purchases of new houses?

Short answer

Low interest rates increase the demand for housing because they decrease the cost of borrowing and increase the buying power of individuals, thereby boosting the demand. The Bureau of Economic Analysis includes the purchases of new houses in the 'Investment' component of the aggregate expenditure.

Step-by-step solution

Understanding the role of interest rates in housing market

In any economy, the interest rate plays a crucial role because it determines the cost of borrowing. When interest rates are low, the cost of borrowing for individuals, including mortgages, decreases. This means more people can afford to take loans and this results in increased demand for housing.

Impact on demand

Low interest rates have a twofold impact on increasing demand for housing. Firstly, as it becomes cheaper to borrow, buying power increases and more people can afford to purchase houses. Secondly, low interest rates also mean that it is less lucrative to save money as the return on the savings is less. This further encourages spending as opposed to saving and thus fuels demand for sectors like housing.

Inclusion in aggregate expenditure

The Bureau of Economic Analysis (BEA) measures the economic activity of a country by using aggregate expenditure which includes consumption, investment, government spending, and net exports. Purchase of new houses falls in the investment component, as investment represents spending on capital goods which includes new residential construction.

Key concepts

Interest Rates and the Housing Market

In the world of economics, interest rates can be thought of as the cost of borrowing money. When interest rates are high, loans become more expensive, and people may hold off on making large purchases that require financing, like homes. Conversely, when interest rates are low, borrowing becomes cheaper. This directly impacts the housing market.

Low interest rates mean that monthly mortgage payments become more affordable for families and individuals. Lower rates translate into lower total interest paid over the life of a loan. Hence, more potential buyers enter the housing market as owning a home becomes financially viable. Additionally, the opportunity cost of saving becomes higher because savings accounts yield lower returns when interest rates are low.

• Lower borrowing costs encourage more home purchases.
• People prefer spending over saving when returns on savings are low.

This phenomenon is why low interest rates are often associated with increased housing demand, as individuals find themselves more capable of purchasing a home than when interest rates are high.

Aggregate Expenditure and Components

Aggregate expenditure is a fundamental concept in macroeconomics that reflects the total spending in an economy. It is composed of four main components: consumption, investment, government spending, and net exports. Each component represents a different part of the economic activity.

Consumption refers to spending by households on goods and services. Government spending entails all expenditures by the government sector. Net exports calculate the difference between what a country exports versus what it imports. Finally, investment, an important part of aggregate expenditure, involves spending on capital goods, including infrastructure and new housing.

Aggregate expenditure plays a crucial role in determining a country's economic output, often measured by Gross Domestic Product (GDP). By understanding what constitutes aggregate expenditure, economists can better gauge the overall economic health and direct economic policies appropriately.

Investment Component and New Houses

When discussing aggregate expenditure, it's essential to understand where specific activities like purchasing new homes fit. The Bureau of Economic Analysis (BEA) classifies the purchase of new houses as part of its investment component. But why exactly are new houses considered under investment rather than consumption?

Investment, in this context, largely refers to the acquisition of new capital goods. Capital goods are used to produce other goods or services in the future. Residential construction, such as buying new houses, qualifies because it is an addition to the capital stock of an economy. These new houses provide long-lasting utilities and thus are investments in the economic sense.

• The investment component is key to understanding economic growth.
• New residential construction adds to the overall capital stock, boosting future output potential.

Therefore, while buying a new house feels like a personal consumption expenditure, it is actually an investment in a larger economic framework.