house market

Money Illusion and Housing Frenzies

Markus K.Brunnermeier y Department of Economics Princeton University

Christian Julliard z Department of Economics London School of Economics

July25,2007

Abstract

A reduction in in‡ation can fuel run-ups in housing prices if people su¤er

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 in‡ation lowers future real mortgage costs.We decom-

pose the price-rent ratio into a rational component–meant to capture the"proxy

e¤ect"and risk premia–and an implied mispricing.We…nd that in‡ation and

nominal interest rates explain a large share of the time-series variation of the

mispricing,and that the tilt e¤ect is very unlikely to rationalize this…nding.

Keywords:Housing,Real Estate,In‡ation,In‡ation Illusion,Mortgages,Behav-

ioral Finance

JEL classi…cation:G12,R2.

We bene…ted from helpful comments from an anonymous referee,Yakov Amihud,Patrick Bolton, Smita Brunnermeier,John Campbell,James Choi,Albina Danilova,Aureo de Paula,Emir Emi-ray,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 sem-inar and conference participants at the Bank of England,Cambridge-Princeton conference,CSEF-IGIER symposium,Duke-UNC Asset Pricing Conference,2006Econometric Society Winter Meet-ings 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 Con-ference on Behavioral Economics.We also thank the BIS for providing part of the housing data used in this analysis.Brunnermeier acknowledges…nancial support from the National Science Foundation and the Alfred P.Sloan Foundation.

y Princeton University,Department of Economics,Bendheim Center for Finance,Princeton,NJ 08544-1021,NBER and CEPR,e-mail:markus@,/ markus z Department of Economics,London School of Economics,Houghton Street,London WC2A2AE, United Kingdom,and CEPR,e-mail:C.Julliard@,/julliard/

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1Introduction

Housing prices have reached unprecedented heights in recent years.Sharp run-ups followed by busts are a common feature of the time-series of housing prices.Figure 1illustrates di¤erent real housing price indices and shows that this phenomenon has been observed in several countries.

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Panel B 5075100125150175200225250275Figure 1:Residential property (real)price indices for a group of Anglo-Saxon countries (Panel A)and for Scandinavian countries and other European countries (Panel B).Base period is 1976:Q1.

Shiller (2005)documents similar patterns for other countries and cities over shorter samples.Moreover,Case and Shiller (1989,1990)document that housing price changes are predictable and suggest that this might be due to ine¢ciency in the housing market.There are several potential reasons for this market ine¢ciency –one of them being money illusion,the inability to properly distinguish changes in nominal values due to changes in real fundamentals from changes merely due to in‡ation.The housing market is particularly well suited to study money illusion,since frictions,e.g.,short-sale constraints,make it di¢cult for professional investors to arbitrage possible mispricings away.

In this paper we identify an empirical proxy for the mispricing in the housing market and show that it is largely explained by movements in in‡ation.In‡ation matters and it matters in a particular way.Our analysis shows that a reduction in in‡ation can generate substantial increases in housing prices in a setting in which agents are prone

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