Inflation Illusion, Credit, and Asset Pricing

Monika Piazzesi and Martin Schneider

No 12957, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: E2 E4 G1 (search for similar items in EconPapers)
Date: 2007-03
New Economics Papers: this item is included in nep-cba, nep-cfn, nep-mac, nep-mon and nep-ure
Note: AP EFG ME
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (11)

Published as “Inflation IlluCampbell, John (ed.) Asset Pricing and Monetary Policy. Chicago, IL: Chicago University Press, 2008.

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