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Nominal mortgage contracts and the effects of inflation on portfolio allocation

  • Joseph B. Nichols
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    Households who wish to extract home equity through refinancing their mortgage face a hidden transaction cost. The real value of the fixed nominal mortgage payment declines over time with inflation. The change in the real value of the mortgage payments from taking on a new mortgage is positive and an increasing function of inflation; higher inflation thus discourages households from re-balancing their portfolio as frequently as they would otherwise. The life cycle model developed in this paper demonstrates how the share of total wealth held in housing is sensitive to the rate of inflation, even when perfectly anticipated. Households hold larger positions in home equity earlier in the life cycle and smaller positions later in the life cycle as the rate of inflation increases.

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    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2007-67.

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    Date of creation: 2007
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    Handle: RePEc:fip:fedgfe:2007-67
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    1. Joao Cocco, 2000. "Hedging House Price Risk With Incomplete Markets," Computing in Economics and Finance 2000 317, Society for Computational Economics.
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    18. Robert F. Martin, 2003. "Consumption, durable goods, and transaction costs," International Finance Discussion Papers 756, Board of Governors of the Federal Reserve System (U.S.).
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