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The wealth effect is the change in spending that accompanies a change in perceived
wealth Wealth is the abundance of valuable financial assets or physical possessions which can be converted into a form that can be used for transactions. This includes the core meaning as held in the originating Old English word , which is from an ...
. Usually the wealth effect is positive: spending changes in the same direction as perceived wealth.


Effect on individuals

Changes in a consumer's wealth cause changes in the amounts and distribution of his or her consumption. People typically spend more overall when one of two things is true: when people ''actually are'' richer, objectively, or when people ''perceive themselves'' to be richer—for example, the assessed value of their home increases, or a stock they own goes up in price. Demand for some goods (called inferior goods) decreases with increasing wealth. For example, consider consumption of cheap fast food versus steak. As someone becomes wealthier, their demand for cheap fast food is likely to decrease, and their demand for more expensive steak may increase. Consumption may be tied to relative wealth. Particularly when supply is highly inelastic, or when the seller is a monopoly, one's ability to purchase a good may be highly related to one's relative wealth in the economy. Consider for example the cost of real estate in a city with high average wealth (for example New York or London), in comparison to a city with a low average wealth. Supply is fairly inelastic, so if a
helicopter drop Helicopter money is a proposed unconventional monetary policy, sometimes suggested as an alternative to quantitative easing (QE) when the economy is in a liquidity trap (when interest rates near zero and the economy remains in recession). Althoug ...
(or
gold rush A gold rush or gold fever is a discovery of gold—sometimes accompanied by other precious metals and rare-earth minerals—that brings an onrush of miners seeking their fortune. Major gold rushes took place in the 19th century in Australia, New Z ...
) were to suddenly create large amounts of wealth in the low wealth city, those who did not receive this new wealth would rapidly find themselves crowded out of such markets, and materially worse off in terms of their ability to consume/purchase real estate (despite having participated in a weak
Pareto improvement Pareto efficiency or Pareto optimality is a situation where no action or allocation is available that makes one individual better off without making another worse off. The concept is named after Vilfredo Pareto (1848–1923), Italian civil engine ...
). In such situations, one cannot dismiss the relative effect of wealth on demand and supply, and cannot assume that these are static (see also General equilibrium). However, according to
David Backus David King "Dave" Backus (April 1953 – June 12, 2016)Obituary
by stock market boom A stock market bubble is a type of economic bubble taking place in stock markets when market participants drive stock prices above their value in relation to some system of stock valuation. Behavioral finance theory attributes stock market bubble ...
in the late 1990s (caused by the dot-com bubble) increased the wealth of Americans, it did not produce a significant change in consumption, and after the crash, consumption did not decrease. Economist Dean Baker disagrees and says that “housing wealth effect” is well-known and is a standard part of economic theory and modeling, and that economists expect households to consume based on their wealth. He cites approvingly research done by Carroll and Zhou that estimates that households increase their annual consumption by 6 cents for every additional dollar of home equity.


In macroeconomics

In macroeconomics, a rise in real wealth increases consumption, shifting the IS curve out to the right, thus pushing up interest rates and increasing aggregate demand. A decrease in real wealth does the opposite.


See also

*
Income effect The theory of consumer choice is the branch of microeconomics that relates preferences to consumption expenditures and to consumer demand curves. It analyzes how consumers maximize the desirability of their consumption as measured by their pre ...
* Income elasticity of demand * Money illusion * Ricardian equivalence * Wealth (economics) * Wealth elasticity of demand


References

{{Wealth Wealth Economics effects