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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. Brunnermeier, Markus K & Julliard, Christian, 2007. "Money Illusion and Housing Frenzies," CEPR Discussion Papers 6183, C.E.P.R. Discussion Papers.
  2. Basak, Suleyman & Yan, Hongjun, 2009. "Equilibrium Asset Prices and Investor Behavior in the Presence of Money Illusion," CEPR Discussion Papers 7398, C.E.P.R. Discussion Papers.
  3. Markus K. Brunnermeier & Christian Julliard, 2006. "Money illusion and housing frenzies," LSE Research Online Documents on Economics 4806, London School of Economics and Political Science, LSE Library.
  4. Matthias Doepke & Martin Schneider, 2006. "Inflation and the Redistribution of Nominal Wealth," Journal of Political Economy, University of Chicago Press, vol. 114(6), pages 1069-1097, December.
  5. 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.
  6. John Y. Campbell & Tuomo Vuolteenaho, 2004. "Inflation Illusion and Stock Prices," NBER Working Papers 10263, National Bureau of Economic Research, Inc.
  7. 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, vol. 120(2), pages 639-668, May.
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Cited by:
  1. Matteo Iacoviello & Stefano Neri, 2008. "Housing market spillovers: Evidence from an estimated DSGE model," Temi di discussione (Economic working papers) 659, Bank of Italy, Economic Research and International Relations Area.
  2. Wei Xiong & Hongjun Yan, 2010. "Heterogeneous Expectations and Bond Markets," Review of Financial Studies, Society for Financial Studies, vol. 23(4), pages 1433-1466, April.
  3. Frappa, S. & Mésonnier, J-S., 2009. "The housing price boom of the late ’90s: did inflation targeting matter?," Working papers 255, Banque de France.
  4. Jianjun Miao & Danyang Xie, . "Monetary Policy and Economic Growth under Money Illusion," Boston University - Department of Economics - Working Papers Series wp2007-045, Boston University - Department of Economics.
  5. Gwangheon Hong & Bong Lee, 2013. "Does Inflation Illusion Explain the Relation between REITs and Inflation?," The Journal of Real Estate Finance and Economics, Springer, vol. 47(1), pages 123-151, July.

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