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Is there a theoretical basis for the view that the end of a period of over-investment necessarily leads to a period of below-normal employment as the excess capital stock is run down? We study the repercussions of a false boom in housing driven by prior expectations of future housing prices not justified by fundamentals. When these expectations are corrected, the result is a precipitous drop in housing prices and, on that account alone, some drop in employment. There is also a bulge in the housing stock. In the case of a closed economy, the downward shift of the term structure of interest rates due to the excess housing stock props up housing prices above the normal steady-state level, so the drop of housing prices undershoots. Although this transient elevation of housing prices has a positive demand-wage effect on employment, we show that the wealth effect from owning a higher housing stock and a negative Hicks-Lucas-Rapping effect of lower interest rates dominate, so employment drops initially to a below-normal level. The slump gradually subsides as the housing overhang wears off. In the case of a small open economy that faces a world of perfect capital mobility and takes as given the world interest rate, there are two possibilities. If housing services are instantaneously tradeable and perfect substitutes for foreign ones so that purchasing power parity holds, the end of the bubble causes housing prices to drop precisely to the steady-state level. Since there is no undershooting, the wealth effect of the housing overhang is unopposed and the slump is deeper. If domestic and foreign housing services are imperfect substitutes, the country will suffer a period with a weak real exchange rate, thus leading to a drop of housing prices that overshoots the normal level. Here, the slump in employment is worsened by the exaggerated fall in housing prices below the steady-state level.

Macroeconomic Effects of Over-Investment in Housing in an Aggregative Model of Economic Activity