RFS Advance Access originally published online on September 20, 2007
Review of Financial Studies 2008 21(1):135-180; doi:10.1093/rfs/hhm043
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Money Illusion and Housing Frenzies
Princeton University
London School of Economics
Address correspondence to Markus K. Brunnermeier, Princeton University, Department of Economics, Bendheim Center for Finance, Princeton, NJ 08540-5296, or e-mail: markus{at}princeton.edu, http://www.princeton.edu/~markus
JEL: G12, R2
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Abstract |
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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.
We benefited from helpful comments from an anonymous referee, Yakov Amihud, Patrick Bolton, Smita Brunnermeier, John Campbell, James Choi, Albina Danilova, Aureo de Paula, Emir Emiray, Will Goetzmann, Kevin Lansing, Chris Mayer, Alex Michaelides, Stefan Nagel, Martin Oehmke, Maureen O'Hara (the editor), Filippos Papakonstantinou, Lasse Pedersen, Adriano Rampini, Matt Richardson, Bob Shiller, Matt Spiegel, Jeremy Stein, Demosthenes Tambakis, Haibin Zhu and seminar and conference participants at the Bank of England, Cambridge–Princeton conference, CSEF–IGIER symposium, Duke–UNC Asset Pricing Conference, 2006 Econometric Society Winter Meetings in Boston, Federal Reserve Bank of Philadelphia, Harvard University, IIES Stockholm, London Business School, London School of Economics, NBER Behavioral Meetings, Oxford University, Queen-Mary University, RFS Bubble Conference in Indiana, University of Copenhagen, University of Salerno, Wharton School, University of Wisconsin–Madison Real Estate Research conference, and Yale Conference on Behavioral Economics. We also thank the BIS for providing part of the housing data used in this analysis. Brunnermeier acknowledges financial support from the National Science Foundation and the Alfred P. Sloan Foundation.