Working Paper: NBER ID: w12957
Authors: Monika Piazzesi; Martin Schneider
Abstract: This paper considers asset pricing in a general equilibrium model in which some, but not all, agents suffer from inflation illusion. Illusionary investors mistake changes in nominal interest rates for changes in real rates, while smart investors understand the Fisher equation. The presence of smart investors ensures that the equilibrium nominal interest rate moves with expected inflation. The model also predicts a nonmonotonic relationship between the price-to-rent ratio on housing and nominal interest rates -- housing booms occur both when the nominal rate is especially low and when it is especially high. In either situation, disagreement about real interest rates between smart and illusionary investors stimulates borrowing and lending and drives up the price of collateral. The resulting housing boom is stronger if credit markets are more developed. We document that many countries experienced a housing boom in the high-inflation 1970s and a second, stronger, boom in the low-inflation 2000s.
Keywords: inflation; asset pricing; credit markets; housing booms
JEL Codes: E2; E4; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| inflation illusion (E31) | housing prices (R31) |
| nominal interest rates (E43) | housing prices (R31) |
| smart investors (G11) | nominal interest rates (E43) |
| illusionary investors (G41) | housing prices (R31) |
| inflation expectations (E31) | housing prices (R31) |
| nominal interest rates (E43) | borrowing and housing demand (R21) |
| housing prices (R31) | housing booms (R31) |