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Money illusion and housing frenzies

By Markus K. Brunnermeier and Christian Julliard

Abstract

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 the fact that inflation lowers future real mortgage costs. We decompose the price–rent ratio into a rational component—meant to capture the "proxy effect" and risk premia—and an implied mispricing. We find that inflation and nominalinterest 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

Topics: HB Economic Theory
Publisher: Oxford University Press
Year: 2008
DOI identifier: 10.1093/rfs
OAI identifier: oai:eprints.lse.ac.uk:4801
Provided by: LSE Research Online
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