In this paper we model the dynamic adjustment of real house prices using data
at the level of US States. We consider interactions between housing markets by
examining the extent to which real house prices at the State level are driven by
fundamentals such as real income, as well as by common shocks, and determine the
speed of adjustment of house prices to macroeconomic and local disturbances. We
take explicit account of both cross sectional dependence and heterogeneity. This
allows us to find a cointegrating relationship between house prices and incomes and
to identify a small role for real interest rates. Using this model we examine the role
of spatial factors, in particular the effect of contiguous states by use of a weighting
matrix. We are able to identify a significant spatial effect, even after controlling
for State specific real incomes, and allowing for a number of unobserved common
factors
