Interest Rates and Space: How Home Size Affects Consumer Spending

In early November, the US Federal Reserve cut interest rates once again, part of its ongoing effort to fulfill its dual mandate of low inflation and low unemployment. To achieve this delicate balancing act, the Fed needs to understand household spending and saving behavior. Characteristics such as peoples’ age and income matter for spending and saving decisions, but much of households’ spending decisions remain a mystery to economists who study this behavior.

“New evidence gathered points to housing characteristics — especially home size and residential density (how tightly packed a neighborhood is) — as key but often overlooked factors shaping household savings, spending habits and, ultimately, the effectiveness of monetary policy (how central banks control interest rates to steer the economy),” says Murphy.

His research suggests that people in smaller homes within dense neighborhoods such as New York City and Tokyo tend to save more and spend less, making it harder for interest rate cuts to stimulate the economy.

The Space Factor: How Home Size Affects Spending

In the U.S., households with similar incomes spend differently depending on whether they live in urban centers or suburbs. Take two households, each earning $150,000: one in Manhattan, the other in a nearby suburb. The Manhattan household, with a smaller home and higher rent, inevitably spends more on housing; Manhattan remains one of the priciest U.S. markets, with median home prices above $1 million in early 2024.

Yet, limited space leads to lower spending on things like utilities, home upkeep, appliances, and even cars — urban households often find public transit and walkable options more economical than owning a vehicle.

In contrast, suburban households, in places such as Guttenberg and Yonkers, though enjoying lower housing costs, end up spending more as they furnish and maintain larger homes. This lifestyle difference leads suburban households to spend more overall, even though their housing is cheaper, resulting in lower savings rates.

Japan: A Case Study in Space and Saving

Japan offers a clear example of how high density and limited living space influence savings and consumption patterns. In the 1990s, the country saw high personal savings rates and persistently low interest rates, often referred to as the “Lost Decade”. This prolonged economic slowdown followed the burst of the asset price bubble in the early 1990s.

Murphy’s research shows that high-density urban environments and smaller average home sizes likely played a key role. In Tokyo, where compact apartments are standard, even rising incomes fail to drive up demand for extra consumer goods — households simply lack the space for more furniture, decor, or storage. Without gardens or multiple rooms to fill, residents have fewer reasons to spend, leading instead to higher savings.

This tendency to save drives down Japan’s natural rate of interest. In fact, high-density living and compact homes have anchored Japan’s savings rates, setting structural limits on spending and reinforcing a cycle of ultra-loose monetary policy that has constrained growth for decades. This year, Japan’s central bank raised interest rates for the first time since 2007.

“A one-percentage-point rate cut is likely to have a bigger impact in the U.S. than in Japan,” explains Murphy. “That’s because Americans have larger homes with more space to fill with new purchases, while Japanese consumers are limited by their compact living spaces.”

Rethinking Economic Policy

Murphy’s research suggests that monetary policy often works better in countries with larger average home sizes. These insights suggest that policymakers should factor in residential density and home size when crafting economic policies. A shift toward suburban living and larger homes, as seen in the U.S. post-COVID-19, could drive up overall spending and reduce the need for ultra-low interest rates to spur demand. This trend toward bigger homes aligns with modest rate hikes since 2020.

Housing in densely populated areas is often limited by land availability, zoning laws, and physical city constraints. Japan and other high-density nations face these challenges, and high saving rates may persist unless policies encourage more — and larger, affordable —housing options. In the U.S., the shift toward working from home may enable employees to live in larger homes in more land-abundant locations (e.g., rural North Carolina rather than New York City), which could spur a long-lasting increase in consumer spending.

The research highlights how housing factors contribute significantly to economic stagnation. Residential density and home size may be just as crucial as demographic trends, like aging populations, in shaping household savings and interest rates.

Understanding the hidden role of housing dynamics — how tightly we live, how big our homes are — could be key to designing economic policies that foster stable economic growth.

UVA Darden Professor Dan Murphy is author of the paper “Home Size, Residential Density, and Aggregate Demand,” which documents that smaller homes and denser neighborhoods are associated with higher household saving rates.