Abstract
We derive a formula for mispricing in the housing market and examine the impact of the inflation rate on mispricing to test the money illusion hypothesis, that asset mispricing results mainly from the inflation rate, and a significantly negative relationship between these two is expected. We employ a Bayesian VAR model to estimate the mispricing in the UK housing market, and regress the estimator on the inflation rate and Economic Sentiment Indicator (ESI) as a proxy for market perception. Our results show that house mispricing in the UK has a significantly positive relationship with the ESI and its component the Confidence Indicators of the Consumer, Retail Trade, Construction, and Services. We find no evidence to support the money illusion hypothesis with there only being an insignificantly negative relationship between mispricing and the inflation rate. Our results can shed light on the formation and dynamic process of house mispricing.