Money Illusion and Housing Frenzies

What is the Money Illusion (via Wikipedia):

In economics, money illusion refers to the tendency of people to think of currency in nominal, rather than real, terms. In other words, the numerical/face value (nominal value) of money is mistaken for its purchasing power (real value). This is a fallacy as modern fiat currencies have no inherent value and their real value is derived from their ability to be exchanged for goods and used for payment of taxes.

Abstract (Via Princeton)

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 expect” 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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05. November 2009 by Miguel Barbosa
Categories: Behavioral Economics, Curated Readings | Leave a comment

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