Inflation Illusion, Credit, and Asset Pricing
AbstractThis paper considers asset pricing in a general equilibrium model in which some, but not all, agents suffer from inflation illusion. Illusionary investors mistake changes in nominal interest rates for changes in real rates, while smart investors understand the Fisher equation. The presence of smart investors ensures that the equilibrium nominal interest rate moves with expected inflation. The model also predicts a nonmonotonic relationship between the price-to-rent ratio on housing and nominal interest rates -- housing booms occur both when the nominal rate is especially low and when it is especially high. In either situation, disagreement about real interest rates between smart and illusionary investors stimulates borrowing and lending and drives up the price of collateral. The resulting housing boom is stronger if credit markets are more developed. We document that many countries experienced a housing boom in the high-inflation 1970s and a second, stronger, boom in the low-inflation 2000s.
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Bibliographic InfoPaper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12957.
Date of creation: Mar 2007
Date of revision:
Publication status: published as “Inflation IlluCampbell, John (ed.) Asset Pricing and Monetary Policy. Chicago, IL: Chicago University Press, 2008.
Note: AP EFG ME
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Find related papers by JEL classification:
- E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment
- E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
- G1 - Financial Economics - - General Financial Markets
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-03-17 (All new papers)
- NEP-CBA-2007-03-17 (Central Banking)
- NEP-CFN-2007-03-17 (Corporate Finance)
- NEP-MAC-2007-03-17 (Macroeconomics)
- NEP-MON-2007-03-17 (Monetary Economics)
- NEP-URE-2007-03-17 (Urban & Real Estate Economics)
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