Money Illusion and Housing Frenzies
Markus K Brunnermeier
The Review of Financial Studies,
Housing; Real Estate; Inflation; Inflation Illusion; Mortgages; Behavioral Finance | behavioural finance; housing; inflation illusion; interest rate; money illusion; mortgages; real estate
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 the fact that inflation lowers future real mortgage costs. We decompose the price-rent ratio into a rational component—meant to capture the 'proxy effect' and risk premia—and an implied mispricing. We find that inflation and nominalinterest rates explain a large share of the time series variation of the mispricing, and that the tilt effect is very unlikely to rationalize this finding. The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please email: firstname.lastname@example.org, Oxford University Press.