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 I ...
.
Usually the wealth effect is positive: spending changes in the same direction as perceived wealth.
Effect on individuals
Changes in a
consumer
A consumer is a person or a group who intends to order, or uses purchased goods, products, or services primarily for personal, social, family, household and similar needs, who is not directly related to entrepreneurial or business activities. ...
'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
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a compan ...
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). Althou ...
(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 ...
) 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). 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
In economics, general equilibrium theory attempts to explain the behavior of supply, demand, and prices in a whole economy with several or many interacting markets, by seeking to prove that the interaction of demand and supply will result in an o ...
).
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 bubbl ...
in the late 1990s (caused by the
dot-com bubble
The dot-com bubble (dot-com boom, tech bubble, or the Internet bubble) was a stock market bubble in the late 1990s, a period of massive growth in the use and adoption of the Internet.
Between 1995 and its peak in March 2000, the Nasdaq Comp ...
) 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
Macroeconomics (from the Greek prefix ''makro-'' meaning "large" + ''economics'') is a branch of economics dealing with performance, structure, behavior, and decision-making of an economy as a whole.
For example, using interest rates, taxes, and ...
, a rise in
real wealth increases consumption, shifting the
IS curve out to the right, thus pushing up interest rates and increasing
aggregate demand
In macroeconomics, aggregate demand (AD) or domestic final demand (DFD) is the total demand for final goods and services in an economy at a given time. It is often called effective demand, though at other times this term is distinguished. This is ...
. A decrease in real wealth does the opposite.
See also
*
Income effect
*
Income elasticity of demand
*
Money illusion
In economics, money illusion, or price illusion, is a cognitive bias where money is thought of in nominal, rather than real terms. In other words, the face value (nominal value) of money is mistaken for its purchasing power (real value) at a prev ...
*
Ricardian equivalence
The Ricardian equivalence proposition (also known as the Ricardo–de Viti–Barro equivalence theorem) is an economic hypothesis holding that consumers are forward-looking and so internalize the government's budget constraint when making their co ...
*
Wealth (economics)
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 I ...
*
Wealth elasticity of demand
References
{{Wealth
Wealth
Economics effects