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 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.