Money Illusion and Housing Frenzies

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 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 very unlikely to rationalize this finding.

Keywords: Behavioural finance, housing, inflation illusion, interest rate, money illusion, mortgages, real estate

JEL Classification: G12, R2