NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Money Illusion and Housing Frenzies

Markus K. Brunnermeier, Christian Julliard

NBER Working Paper No. 12810
Issued in December 2006
NBER Program(s):   AP   EFG   ME

A reduction in inflation can fuel run-ups in housing prices if people suffer from money illusion. For example, investors who decide whether to rent or buy a house by simply comparing monthly rent and mortgage payments do not take into account that inflation lowers future real mortgage costs. We decompose the price-rent ratio in a rational component -- meant to capture the proxy effect and risk premia -- and an implied mispricing. We find that inflation and nominal interest rates explain a large share of the time-series variation of the mispricing, and that the tilt effect is unlikely to rationalize this finding.

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Document Object Identifier (DOI): 10.3386/w12810

Published: Markus K. Brunnermeier & Christian Julliard, 2008. "Money Illusion and Housing Frenzies," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 21(1), pages 135-180, January.

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