Money Illusion and Housing Frenzies

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.

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