Alternative explanation of the money illusion: The effect of unexpected low inflation

Abstract

In this study, a theoretical framework was constructed to verify whether the inflation level determines the presence of money illusion. The unexpected occurrence of low inflation is typically taken as an indication that the economy has entered or is entering a recession, and people expect the Federal Reserve to rapidly intervene to recover the economy. Because rental contracts facilitate rent price rigidity, rent prices may not decline immediately in the presence of unexpected low inflation, causing house owners in general to consider their rent returns as still lucrative. The excess profits from the rent returns of house owners can be used to compensate potential loss incurred from falling housing prices in the future, subsequently reducing their risk of property ownership. Therefore, when encountering unexpected low inflation, house owners tend to lower their expectations of housing return risk and overestimate the housing price, thus resulting in money illusion effects. A long-term data set of the US housing market (sample period: 1960 Q1 – 2016 Q1) was employed to comprehensively estimate the biases of the price–rent ratio. The estimation results revealed that money illusion effects only exist in conditions with minimal commodity price increases or decreases, which comply with the hypothesis of the present study. Finally, this study evaluated expected housing risk and housing premiums and confirmed that unexpected low inflation increases housing premiums, consequently leading to a higher rise in housing prices than in rent prices and contributing to the mispricing of price–rent ratios.