Falling Real Interest Rates, House Prices, and the Introduction of the Pill

Lu, J. and Teulings, C.

The past 30 years has witnessed a worldwide decrease in real interest rates. Simultaneously over this period house prices have grown in real terms. We demonstrate that these trends can be explained by changes in demographic structure associated with the introduction of the pill in the early 1970s. Following this, most of the western world, Japan and China saw similar reductions in fertility rates, though timing and magnitude differ among countries. In the long-run this leads to lower population growth. In the short-run the cohort born just before the introduction of the pill are disproportionally larger than cohorts born before and after. As this large cohort accumulates assets for retirement, aggregate savings supply increases which results in falling real interest rates and rising house prices. We find that an increase in house prices over the past decades was likely an efficient outcome that aided efficiency in the transition towards the new balanced growth path. However, housing's appreciation is a feature that can't be easily explained in a rational framework. Our model predicts that real interest rates will continue to fall, overshooting the new balanced growth path level until hitting a trough at around the year 2035.