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Money Illusion and Housing Frenzies

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Author Info
Markus K Brunnermeier
Christian Julliard ()

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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 very unlikely to rationalize this finding.Keywords: Housing, Real Estate, Inflation, Inflation Illusion, Mortgages, Behavioral FinanceJEL classification: G12, R2. 

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Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp579.

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Date of creation: Jul 2006
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Handle: RePEc:fmg:fmgdps:dp579

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  1. Matteo Iacoviello & Stefano Neri, 2007. "Housing Market Spillovers: Evidence from an Estimated DSGE Model," Boston College Working Papers in Economics 659, Boston College Department of Economics, revised 23 Oct 2009. [Downloadable!]
    Other versions:
  2. Ralph S.J Koijen & Otto Van Hemert & Stijn Van Nieuwerburgh, 2007. "Mortgage Timing," NBER Working Papers 13361, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  3. Robert J. Shiller, 2007. "Low Interest Rates and High Asset Prices: An Interpretation in Terms of Changing Popular Models," Cowles Foundation Discussion Papers 1632, Cowles Foundation, Yale University. [Downloadable!]
  4. Robert J. Shiller, 2007. "Low Interest Rates and High Asset Prices: An Interpretation in Terms of Changing Popular Economic Models," NBER Working Papers 13558, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  5. Hott, Christian, 2009. "Explaining House Price Fluctuations," Working Papers 2009-5, Swiss National Bank. [Downloadable!]
  6. Andrea Finicelli, 2007. "House price developments and fundamentals in the United States," Questioni di Economia e Finanza (Occasional Papers) 7, Bank of Italy, Economic Research Department. [Downloadable!]
  7. Maik Schmeling & Andreas Schrimpf, 2008. "Expected Inflation, Expected Stock Returns, and Money Illusion: What can we learn from Survey Expectations?," SFB 649 Discussion Papers SFB649DP2008-036, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany. [Downloadable!]
  8. Carl Chen & Peter Lung & F. Wang, 2009. "Mispricing and the cross-section of stock returns," Review of Quantitative Finance and Accounting, Springer, vol. 32(4), pages 317-349, May. [Downloadable!] (restricted)
  9. Robert J Shiller, 2007. "Low Interest Rates and High Asset Prices: An Interpretation in Terms of Changing Popular Models," Levine's Bibliography 122247000000001682, UCLA Department of Economics. [Downloadable!]
  10. Monika Piazzesi & Martin Schneider, 2007. "Inflation Illusion, Credit, and Asset Pricing," NBER Working Papers 12957, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  11. Eerola, Essi & Määttänen, Niku, 2008. "On the importance of borrowing constraints for house price dynamics," Research Discussion Papers 8/2008, Bank of Finland. [Downloadable!]
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