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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 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

Topics: HB Economic Theory
Publisher: National Bureau of Economic Research
Year: 2006
OAI identifier: oai:eprints.lse.ac.uk:4815
Provided by: LSE Research Online
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