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 effect" and risk premia{\textendash}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.
}, year = {2008}, journal = {The Review of Financial Studies}, volume = {21}, number = {1}, pages = {135-180}, note = {The confusion between changes in nominal and real interest rates boosts real house prices when inflation declines.
}, language = {eng}, }