Inflation Illusion, Credit, and Asset Prices
Inflation Illusion, Credit, and Asset Prices
This chapter considers the effect of inflation illusion on asset prices in a general equilibrium model with heterogeneous agents. The model predicts a nonmonotonic relationship between house price-rent ratios and inflation: house prices are high whenever inflation is far away from its historical average. According to the model, a high-inflation environment—such as the 1970s—is a time when smart households drive up house prices because they are able to borrow cheaply from illusionary households. The latter do not realize that nominal rates are high only because expected inflation is high and thus perceive higher real rates than smart households. In contrast, in a low-inflation environment—such as the 2000s—the role of the two groups is reversed: illusionary households drive up house prices because they think they are borrowing cheaply from smart households. They do not realize that nominal interest rates are low only because of low expected inflation and thus perceive lower real rates than smart households. The cross-country evidence in this chapter also shows that the price-dividend ratios of housing and stocks often move in opposite directions.
Keywords: inflation, asset prices, house prices, borrowing, housing, stock prices, interest rates, stocks
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