Money Illusion and Housing Frenzies

Posted: 26 Jun 2008

See all articles by Markus K. Brunnermeier

Markus K. Brunnermeier

Princeton University - Department of Economics

Christian Julliard

London School of Economics & Political Science (LSE) - Department of Finance; Centre for Economic Policy Research (CEPR)

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Date Written: January 2008

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.

JEL Classification: G12, R2

Suggested Citation

Brunnermeier, Markus Konrad and Julliard, Christian, Money Illusion and Housing Frenzies (January 2008). The Review of Financial Studies, Vol. 21, Issue 1, pp. 135-180, 2008, Available at SSRN: https://ssrn.com/abstract=1151578 or http://dx.doi.org/10.1093/rfs/hhm043

Markus Konrad Brunnermeier (Contact Author)

Princeton University - Department of Economics ( email )

Bendheim Center for Finance
Princeton, NJ
United States
609-258-4050 (Phone)
609-258-0771 (Fax)

HOME PAGE: http://www.princeton.edu/¡­markus

Christian Julliard

London School of Economics & Political Science (LSE) - Department of Finance ( email )

United Kingdom

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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