DP6183 Money Illusion and Housing Frenzies

Author(s): Markus K Brunnermeier, Christian Julliard
Publication Date: March 2007
Keyword(s): behavioural finance, housing, inflation illusion, interest rate, money illusion, mortgages, real estate
JEL(s): G12, R2
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6183

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 very unlikely to rationalize this finding.