Wealth Effect

The wealth effect is the tendency of households to change their spending when the value of their wealth changes, even if their income stays the same. When house prices or share prices rise, owners feel richer and tend to spend somewhat more; when those values fall, they tend to cut back. The effect links asset markets to the real economy and is one of the channels through which monetary policy works.

The idea rests on theories of consumption that say people base spending on their lifetime resources, not only on this month's pay. It is related to, but distinct from, the older "real balance" or Pigou effect, in which falling prices raise the real value of money holdings. Economists measure the wealth effect as a marginal propensity to consume out of wealth, a close cousin of the marginal propensity to consume out of income.

Picture a couple whose home has gone up a lot in value. Their salaries haven't changed, but they feel more secure about retirement, so they finally renovate the kitchen, perhaps borrowing against the house to do it. Their neighbours, who rent, feel no such boost.

Now imagine the opposite: the stock market slumps and a retired teacher sees her savings shrink. She postpones a trip and eats out less. Neither household's income changed, but their spending did, because what they own was worth more or less than before.

The simplest way to express the wealth effect is:

• $\Delta C$ is the change in annual consumer spending.
• $m_{W}$ is the marginal propensity to consume out of wealth, the extra spending per extra unit of wealth.
• $\Delta W$ is the change in household wealth.

If US stock-market wealth rises by $2 trillion and households spend 3 cents of each extra dollar a year, then $\Delta C = 0.03 \times 2{,}000 = 60$, or $60 billion of additional spending. Because that spending is someone else's income, the eventual effect on output can be larger through the multiplier effect.

Franco Modigliani's life-cycle hypothesis and Milton Friedman's permanent income hypothesis both predict a wealth effect: a lasting rise in wealth raises the resources a household can spread over its lifetime, so it can afford to spend a little more each year and save a little less. Empirical estimates vary with country, period and method, but many US studies find that households spend a few cents a year for each extra dollar of stock-market wealth. Studies of housing differ more. Karl Case, John Quigley and Robert Shiller found housing wealth effects at least as large as stock-market effects, and Atif Mian, Kamalesh Rao and Amir Sufi estimated that US households cut spending by roughly 5 to 7 cents per dollar of lost housing wealth in 2006–2009, with much bigger cuts among poorer, more indebted households. Other economists argue that higher house prices mostly shift wealth between owners and future buyers rather than making the country richer, so the aggregate effect is smaller than it looks.

• Who owns the assets. Shares are concentrated among wealthier households, who spend a small fraction of gains; housing wealth is spread more widely.
• Access to credit. Homeowners can turn price gains into spending by borrowing against their homes, so mortgage rules matter; falling prices can leave owners in negative equity and force sharp cuts.
• Permanence. Households respond more to gains they expect to last than to gains during a suspected bubble.
• Retirement systems. Where savings are locked in pension funds, paper gains may have less immediate effect on spending.

Central banks count the wealth effect among the ways lower interest rates and quantitative easing support demand: lower yields push up the prices of shares, bonds and property, and higher wealth encourages spending. The same channel works in reverse when policy tightens. Critics argue that relying on asset prices to support demand widens wealth inequality, because the gains go mainly to those who already own assets, and that it can encourage the kind of debt-fuelled spending that ends in a boom and bust. Supporters reply that the main goal is jobs and stable prices, and that rising employment benefits lower-income households too. The wealth effect also shapes how downturns unfold: falling share and house prices after the 2008 financial crisis cut spending just as incomes fell, adding to the weakness in consumer confidence.

• Federal Reserve Board: Distributional Financial Accounts
• Federal Reserve Board: Financial Accounts of the United States (Z.1)