The wealth effect theory suggests that as consumers perceive their wealth to increase, their spending also increases. This is often influenced by rising home and stock values, which boost consumer confidence. However, not all economists believe in this theory, citing examples like the dot.com boom and bust of the early 2000s.
The wealth effect is an economic theory of consumption habits that holds that as consumers’ perceived wealth increases, consumption increases. Consumers’ perceptions of their net worth often depend on assets such as stocks and real estate, in addition to liquid assets such as cash and bank accounts. Unlike the bank teller, however, real estate and stock values are just wealth on paper and do not represent real wealth until they are sold, possibly at a lower price. Until an actual sale, the increase in value is just a market judgment of potential wealth.
The economic phenomenon of the wealth effect owes its power to consumer psychology. Rising home values and stock prices on paper make consumers feel more confident. Feeling more confident, they spend more and are more willing to buy goods and services, obtaining more credit.
Demand does not increase for all goods as consumers feel wealthier. As consumer wealth increases, some consumers begin to spurn cheaper products and trade in more expensive items. For example, under the wealth effect, instead of buying small, fuel-efficient cars, consumers might buy larger, more expensive SUVs with low mileage.
Economists who have studied the phenomenon have quantified its effects. Generally, they found that the wealth effect caused by rising house or stock prices increases consumer spending by 2-9% for every dollar of increased wealth. One study found that the wealth effect resulting from rising house prices increased consumer spending more than the wealth effect due to higher stock prices.
The wealth effect is often cited by economists when reviewing consumer spending or confidence. Ben Bernanke, chairman of the Federal Reserve, wrote in an article published for The Washington Post in November 2010 that the Fed’s purchase of $600 billion in U.S. government dollars (USD) in government bonds, the Fed’s second attempt of quantitative easing to stimulate the US economy, would cause stock prices to rise. Those who believe in the wealth effect caused by rising securities and housing generally assume that declining house and stock prices can have a reverse wealth effect, in which decreasing consumer confidence in perceived wealth can cause consumers to control spending.
However, not all economists subscribe to the wealth effect theory. Some point to the dot.com boom of the late 1990s and subsequent bust of the early 2000s. The boom and bust produced no significant rise or fall in consumer consumption, they say.
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