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Inflation Illusion, Credit, and Asset Pricing

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  • Monika Piazzesi
  • Martin Schneider

Abstract

This 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 Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12957.

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Date of creation: Mar 2007
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Publication status: published as “Inflation IlluCampbell, John (ed.) Asset Pricing and Monetary Policy. Chicago, IL: Chicago University Press, 2008.
Handle: RePEc:nbr:nberwo:12957

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  1. Basak, Suleyman & Yan, Hongjun, 2009. "Equilibrium Asset Prices and Investor Behavior in the Presence of Money Illusion," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7398, C.E.P.R. Discussion Papers.
  2. Markus K. Brunnermeier & Christian Julliard, 2006. "Money illusion and housing frenzies," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 4806, London School of Economics and Political Science, LSE Library.
  3. John Y. Campbell & Tuomo Vuolteenaho, 2004. "Inflation Illusion and Stock Prices," American Economic Review, American Economic Association, American Economic Association, vol. 94(2), pages 19-23, May.
  4. Markus K. Brunnermeier & Christian Julliard, 2006. "Money Illusion and Housing Frenzies," NBER Working Papers 12810, National Bureau of Economic Research, Inc.
  5. Randolph B. Cohen & Christopher Polk & Tuomo Vuolteenaho, 2005. "Money Illusion in the Stock Market: The Modigliani-Cohn Hypothesis," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 120(2), pages 639-668, May.
  6. Matthias Doepke & Martin Schneider, 2006. "Inflation and the Redistribution of Nominal Wealth," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 114(6), pages 1069-1097, December.
  7. Steven A. Sharpe, 2002. "Reexamining Stock Valuation and Inflation: The Implications Of Analysts' Earnings Forecasts," The Review of Economics and Statistics, MIT Press, vol. 84(4), pages 632-648, November.
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Cited by:
  1. Gwangheon Hong & Bong Lee, 2013. "Does Inflation Illusion Explain the Relation between REITs and Inflation?," The Journal of Real Estate Finance and Economics, Springer, Springer, vol. 47(1), pages 123-151, July.
  2. Matteo Iacoviello & Stefano Neri, 2008. "Housing market spillovers : evidence from an estimated DSGE model," Working Paper Research, National Bank of Belgium 145, National Bank of Belgium.
  3. Wei Xiong & Hongjun Yan & Review Financial, 2007. "Heterogeneous Expectations and Bond Markets," Yale School of Management Working Papers, Yale School of Management amz2614, Yale School of Management, revised 01 Jun 2009.
  4. Frappa, S. & Mésonnier, J-S., 2009. "The housing price boom of the late ’90s: did inflation targeting matter?," Working papers, Banque de France 255, Banque de France.
  5. Jianjun Miao & Danyang Xie, . "Monetary Policy and Economic Growth under Money Illusion," Boston University - Department of Economics - Working Papers Series, Boston University - Department of Economics wp2007-045, Boston University - Department of Economics.

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