Browsing by Author "Piippo, Iida"

Housing prices in many countries have experienced large run-ups and downturns which indicates that the housing market is not working efficiently. Understanding the factors affecting the house price movement is important to be able to prevent radical price changes and maintain economic stability. One cause for the inefficiency in the housing market has been proposed to be the money illusion. Money illusionary agents make inflation adjustment errors by discounting the future real payoffs with nominal rather than real interest rate. This irrational behavior of agents has been shown to cause pricing errors especially at the times when inflation is exceptionally high or low. The money illusion hypothesis has widely been studied in the context of the financial and housing market. This thesis contributes to the existing literature by studying if there is evidence of the money illusion in the Finnish housing market. Many of the studies have focused on the major economic markets like the UK and the US, so there are not many studies from the perspective of a national market with different institutional setting and market features. The empirical framework is based on the decomposition of the price-rent ratio. The intention is to differentiate the fundamentals of the housing market to study how different unobservable factors affect housing. Housing is considered as a dividend paying asset as in the financial market approach. The study shows that there is a link between inflation and price-rent ratio. Inflation can affect prices through the rational component, risk premia or pricing errors. Money illusion suggests that inflation affect prices through the pricing error. In the model, the agents are allowed to have subjective expectations in order to be able to obtain the pricing error which is the difference between the rational agents objective expectations and irrational agents subjective expectations. The results from the Finnish housing market differ from other studies documenting strong evidence in favor of the money illusion. There is no strong evidence to the hypothesis that inflation and nominal interest rate would explain the movements in the pricing error. However, the rational component and the risk premia of the housing are highly correlated with inflation and nominal interest rates. The results of this study show more support for the rational channels than to the irrational channels for explaining the detected link between housing prices and inflation. The study also shows that part of the correlation between inflation and price-rent ratio can be explained by business cycle fluctuations. Thus, the study does not find strong evidence of money illusion having an effect on the Finnish housing market.