Inflation Illusion, Credit, and Asset Pricing

45 Pages Posted: 15 Mar 2007 Last revised: 23 Apr 2007

See all articles by Monika Piazzesi

Monika Piazzesi

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

Martin Schneider

Independent

Date Written: March 2007

Abstract

This paper considers asset pricing in a general equilibrium model in which some, but not all, agents suffer from inflation illusion. Illusionary investors mistake changes in nominal interest rates for changes in real rates, while smart investors understand the Fisher equation. The presence of smart investors ensures that the equilibrium nominal interest rate moves with expected inflation. The model also predicts a nonmonotonic relationship between the price-to-rent ratio on housing and nominal interest rates -- housing booms occur both when the nominal rate is especially low and when it is especially high. In either situation, disagreement about real interest rates between smart and illusionary investors stimulates borrowing and lending and drives up the price of collateral. The resulting housing boom is stronger if credit markets are more developed. We document that many countries experienced a housing boom in the high-inflation 1970s and a second, stronger, boom in the low-inflation 2000s.

Suggested Citation

Piazzesi, Monika and Schneider, Martin, Inflation Illusion, Credit, and Asset Pricing (March 2007). NBER Working Paper No. w12957. Available at SSRN: https://ssrn.com/abstract=971592

Monika Piazzesi (Contact Author)

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Martin Schneider

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