Money Illusion and Housing Frenzies
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- 20 September 2007
- journal article
- research article
- Published by Oxford University Press (OUP) in The Review of Financial Studies
- Vol. 21 (1) , 135-180
- https://doi.org/10.1093/rfs/hhm043
Abstract
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 nominal interest 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.Keywords
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