Money Illusion and Housing Frenzies
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.
We benefited from helpful comments from an anonymous referee, Yakov Amihud, Patrick Bolton, Smita Brunnermeier, John Campbell, James Choi, Albina Danilova, Aureo de Paula, Emir Emiray, Will Goetzmann, Kevin Lansing, Chris Mayer, Alex Michaelides, Stefan Nagel, Martin Oehmke, Maureen O'Hara, Filippos Papakonstantinou, Lasse Pedersen, Adriano Rampini, Matt Richardson, Bob Shiller, Matt Spiegel, Jeremy Stein, Demosthenes Tambakis, Haibin Zhu and seminar and conference participants at the Bank of England, Cambridge-Princeton conference, CSEFIGIER symposium, Duke-UNC Asset Pricing Conference, 2006 Econometric Society Winter Meetings in Boston, Federal Reserve Bank of Philadelphia, Harvard University, IIES Stockholm, London Business School, London School of Economics, NBER Behavioral Meetings, Oxford University, Queen-Mary University, RFS Bubble Conference in Indiana, University of Copenhagen, University of Salerno, Wharton School, University of Wisconsin-Madison Real Estate Research conference, and Yale Conference on Behavioral Economics. We also thank the BIS for providing part of the housing data used in this analysis. Brunnermeier acknowledges financial support from the National Science Foundation and the Alfred P. Sloan Foundation. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.
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. citation courtesy of