The recent boom-and-bust cycle in housing prices has refreshed the debate on the drivers of housing cycles as well as the appropriate policy response. We analyze the case of Spain, where housing prices have soared since it joined the EMU. We present evidence based on a VAR model, and we calibrate a New Keynesian model of a currency area with durable goods to explain it. We find that labor market rigidities provide stronger amplification effects to all type of shocks than financial frictions do. Finally, we show that when the central bank reacts to house prices, the non-durable sector suffers an important contraction. As a result, the boom-and-bust cycle would not have been avoided if Spain had remained outside the EMU during the 1996-2007 period.

The recent boom and bust cycle in housing prices in many advanced economies has refreshed the debate on the drivers of housing cycles and the role of the housing sector in amplifying economic volatility, as well as the appropriate response of the monetary authorities. The case of Spain is of special interest since its recent economic expansion has been characterized by sustained growth of residential investment, private consumption, credit and housing prices for more than a decade. Moreover, during this period nominal and real interest rates fell to exceptionally low levels during the convergence period in order to enter the European Economic and Monetary Union (EMU). As a result, a large current account deficit emerged, reaching almost 10 percent of GDP at the peak of the cycle in 2007. In addition to growing external imbalances, a special source of concern for the Spanish economy was the loss of monetary policy autonomy after entering the EMU. In countries with their own national currency and monetary policy, such as the US, the UK, Australia and New Zealand, the central bank can increase interest rates to slow down the growth rate of housing prices (although in practice they were not successful in doing so in the most recent cycle), and also respond to a housing price collapse. However, Spain belongs to the EMU, and the European Central Bank sets rates according to the inflation rate of the Harmonized Index of Consumer Prices (HICP) of the Euro area as a whole. This means that monetary policy cannot be the first line of defense in response to negative sector-and country-specific shocks.