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Money Illusion and Housing Frenzies

  • Markus K. Brunnermeier
  • Christian Julliard

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 unlikely to rationalize this finding.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12810.

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Date of creation: Dec 2006
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Publication status: published as Markus K. Brunnermeier & Christian Julliard, 2008. "Money Illusion and Housing Frenzies," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 21(1), pages 135-180, January.
Handle: RePEc:nbr:nberwo:12810
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