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NBER WORKING PAPER SERIES

MONEY ILLUSION AND HOUSING FRENZIES Markus K. Brunnermeier Christian Julliard Working Paper 12810 http://www.nber.org/papers/w12810

NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 December 2006

We benefited from helpful comments from an anonymous referee, Yakov Amihud, Patrick Bolton, Smita Brunnermeier, John Campbell, JamesChoi, Albina Danilova, Aureo de Paula, Emir Emiray, Will Goetzmann, Kevin Lansing, Chris Mayer, Alex Michaelides, Stefan Nagel, Martin Oehmke, Maureen O'Hara, 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-Princetonconference, CSEFIGIER 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, WhartonSchool, 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. The views expressed herein are those of the author(s) and do not necessarily reflectthe views of the National Bureau of Economic Research. © 2006 by Markus K. Brunnermeier and Christian Julliard. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

Money Illusion and Housing Frenzies Markus K. Brunnermeier and Christian Julliard NBER WorkingPaper No. 12810 December 2006 JEL No. G12,R2 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 that inflation lowers future real mortgage costs. We decompose the price-rent ratio in a rationalcomponent -- 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 unlikely to rationalize this finding. Markus K. Brunnermeier Princeton University Department of Economics Bendheim Center for Finance Princeton, NJ 08540 and NBERmarkus@princeton.edu Christian Julliard Department of Economics London School of Economics Houghton Street London, WC2A 2AE United Kingdom C.Julliard@lse.ac.uk

1

Introduction

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 1 illustrates different real housing price indicesand shows that this phenomenon has been observed in several OECD countries.
Panel A
275 250 225 200 175 150 125
100

275 250 225 200 175 150 125

P anel B

100
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50 1970 1974 1978 1982 1986 1990 1994 1998 2002
US UK CA AU

1970

1974

1978
NL SE

1 98 2

1986
DK CH

1990

1994
NO

1998

2002

Figure 1: Residential property (real) price indices for agroup 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 inefficiency in the housing market....
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