What is the Wealth Effect?

What is the Wealth Effect?

The wealth effect is a behavioral economic theory suggesting that people spend more as the value of their assets rise. The idea is that consumers feel more financially secure and confident about their wealth when their homes or investment portfolios increase in value. They are made to feel richer, even if their income and fixed costs are the same as before.

The wealth effect posits that consumers feel more financially secure and confident about their wealth when their homes or investment portfolios increase in value.

They are made to feel richer, even if their income and fixed costs are the same as before.

How does the Wealth Effect Work?

Besides the correlation between consumer spending and wealth effect, organizations also start hiring on an increased level and making capital expenditures in lieu of rising asset prices. Market experts are still trying to find the authenticity of the wealth effect in the stock market.

 There are experts who are of the view that this effect is more related to correlation rather than causation, stating that an increase in spending levels results in asset appreciation. There is solid evidence proving that increased expenditure results in increasing the value of a property.

Supporters of the wealth effect say that if interest rates are less and credit is more easily availed, the consumers will be tempted to buy more. This proves to be true for the housing sector. If interest rates are less, there will be more sales of homes. And as demand exceeds supply in this case, this will ultimately increase the worth of homes.

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Why the Wealth Effect Matters

Historically, during bull markets (defined in the first section of this piece), raising taxes and interest rates have not impacted the volume of consumer spending. The phenomenon is sometimes theorized as the cause of this surprising reality.

Evaluation of wealth effect

  • The link between wealth and spending is smaller than the link between income and wealth.
  • It is harder to translate wealth into money which can be spent. For example, banks may not be willing to give a bigger mortgage – despite the rise in house prices.
  • Rising house prices will not make everyone feel better off. If house prices rise, then it is not much as people may feel if they sell house, they will just have to spend more moving elsewhere.
  • It depends on the wealth bracket. If wealth increases for the very wealthy – they may have a lower marginal propensity to consume from increased wealth as they don’t have any pressing spending needs. However, for those on relatively low incomes, a rise in wealth – may be the only way they can afford one off expenditures such as home extension or several years of school feeds.
  • It depends whether an increase in wealth is volatile or permanent. A rise in share prices can be quite volatile. Most people don’t see share equity as sources of spending. If share prices rise or fall – it has little effect on spending in the short-term.
  • Housing wealth in the UK has often had a significant effect on the economy. This is because many households own a house and it is by far the biggest forms of wealth. In Germany, there is a lower percentage of the population who own a house, changes in house prices have a smaller impact on the economy.
  • It is hard to separate cause and effect. Falling house prices cause lower spending and lower growth. But, lower spending and recession – cause falling house prices.
  • Rising house prices can reduce the spending power of renters. If house prices rise, homeowners (around 65% of households) will see a rise in wealth. However, for those who do not own their own house, they may need to save more for a deposit and actually reduce spending.
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Example of The Wealth Effect

Proponents of the wealth effect can point to several occasions when significant interest rate and tax increases during bull markets failed to put the brakes on consumer spending. Events in 1968 offer a good example.

Taxes were hiked by 10%, yet people continued to spend more. Even though disposable income declined because of the additional tax burden, wealth continued to grow as the stock market persistently climbed higher.

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