The Reality of the Real Rate

Abstract

Prevailing economic theory suggests an important distinction between nominal and real values. This concept of purchasing power helps explain the motivation behind basic economic decisions such as whether to invest, save, or consume. Consumers and businesses that make decisions without consideration of purchasing power are assumed to exhibit “money illusion”, the failure to adjust nominal values for changes in prices. The standard assumption used for macroeconomic theory and modeling is that consumers and investors lack money illusion, that is, their consumption and investment responds to real variables. This study tests this standard assumption, and examines the effects of nominal and real interest rates on home buying attitudes using micro-data from the University of Michigan: Survey of Consumers. More specifically, the purpose of this research is to compare the impact of various mortgage rates on home buying optimism including the traditional 30-year-fixed rate, the personal real rate calculated using respondents’ one and five-year inflation expectations, and the market real rate calculated from the 30-year TIPS breakeven rate. This is the first study that tests person-specific real rates generated from survey data in addition to market-wide real rates to answer this question. Across all models, results reveal that the nominal rate is more highly influential than real rates in determining home buying optimism. These results have implications for further adjustment to standard macroeconomic modeling.