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What is the Wealth Effect?
The wealth effect is an economic theory of spending habits that holds that as consumers' perceived wealth increases, consumer consumption rises. Consumers' perceptions of their net worth typically depend on assets like stocks and real estate, in addition to liquid assets like cash and bank accounts. Unlike cash in the bank, however, real estate and stock values are merely wealth on paper and do not represent real wealth until sold, possibly at a lower price. Until an actual sale, increased value is just a market judgment of potential wealth.
The economic phenomenon of the wealth effect owes its power to consumer psychology. The increased value of housing and stock prices on paper makes consumers feel more confident. Feeling more confident, they spend more and become more willing to buy goods and services by taking out more credit.
Demand does not increase for all goods as consumers feel wealthier, however. As consumer wealth increases, some consumers begin to snub cheaper goods and trade up to more expensive items. For instance, under the wealth effect, rather than buying small, fuel-efficient automobiles, consumers might purchase big, more expensive SUVs with poor gas mileage.
Economists who have studied the phenomenon have quantified its effects. Generally, they have found that the wealth effect caused by rising real estate or stock prices increases consumer spending by 2 to 9 percent for each dollar of increased wealth. One study found that the wealth effect from rising housing prices increased consumer spending more than the wealth effect from higher stock prices.
The wealth effect is often cited by economists when reviewing consumer spending or consumer confidence. Ben Bernanke, chairman of the Federal Reserve, wrote in an op-ed piece for The Washington Post in November 2010 that the Fed's purchase of $600 billion US Dollars (USD) in government bonds, the Fed's second attempt at 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 prices usually concede that declining housing and stock prices can bring on a reverse wealth effect, in which declining consumer confidence about perceived wealth can cause consumers to rein in spending.
Not all economists subscribe to the wealth-effect theory, however. Some point to the dot.com boom of the late 1990s and the subsequent bust of the early 2000s. The boom and bust yielded no significant increase or decrease in consumer consumption, they say.
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![Ben Bernanke, chairman of the Federal Reserve, said the Fed's purchase of $600 billion dollars in government bonds would cause stock prices to rise and combat economic stagnation.]()
By: qingwaBen Bernanke, chairman of the Federal Reserve, said the Fed's purchase of $600 billion dollars in government bonds would cause stock prices to rise and combat economic stagnation. -
![As a consumer's perceived wealth increases, so too does their spending increase.]()
By: David DavisAs a consumer's perceived wealth increases, so too does their spending increase. -
![Real estate values only represent wealth on paper, not real wealth, unless they are sold.]()
By: Stephen VanHornReal estate values only represent wealth on paper, not real wealth, unless they are sold.
Discussion Comments
@miriam98 - The idea of a bailout sort of goes against the whole principle of capitalism, though. According to free market ideas, companies like Ford and GM should have been allowed to go out of business, and the foreign companies would have taken up the slack. If the car companies were offering products that Americans wanted and could compete with foreign automobiles, they shouldn't have been in trouble in the first place.
That's a very simplified version, though, since a lot of things played into the final decision. If you did let all of the American car companies fall through, competition would have decreased, and the overseas companies inevitably would have raised prices. Like you alluded to, as well, keeping an American company afloat more directly improves American's economy.
I really don't know what the right answer was. Another big reason that the car companies and a lot of the other companies were in such trouble is the way their companies were arranged. The CEOs of those companies make far, far more than CEOs of any other foreign companies that are doing much better, which is part of the issue.
I still think it is fair to say that in some cases, perceived wealth really does equate to higher realized wealth. If you are a very good money manager in terms of your stocks portfolio, you can effectively manage your assets to benefit yourself.
If you see the signs that a stock is starting to drop, and you sell for a large profit, you have just turned your perceived wealth into a tangible form of money that you can spend. If you wisely reinvest, but skim a little off the top for yourself, you eventually get to the point where you have increased the threshold of your overall standard of living. In other words, even in bad markets, you will have more income being generated than you would if you had never invested in stocks in the first place.
Of course, most people are not Warren Buffett, and investing is not something that everyone can be good at. For those that can successfully assess risks, though, the wealth effect might not matter.
@TreeMan - I would say you might be onto something with your comment, but to add to it, I think it may be different for everyone. I have friends that were raised in upper class, wealthy families, and some of them don't have the slightest idea how to manage their spending, and some of them are very good about it, and in both cases, their parents were good at it. On the other hand, I have friends that didn't necessarily grow up in poverty, but were in the lower middle class. Those friends now have good jobs and have done well for themselves, but again, some are good about spending and some aren't.
I am thinking maybe it is just sort of a personal thing. Somewhere during a person's life they start to make their own decisions about the best ways to think about and spend money. I figure a lot of things play into it. I figure the values parents teach are a lot of it, but I'm sure it's really just an addition of lots of little things that accumulate.
@simrin - Kind of along the same line as what you are talking about, I am curious if the wealth effect has different outcomes depending on someone's personality. Maybe either in terms of risk adverseness or maybe even things like overall upbringing.
Personally, I don't think the wealth effect has too much sway on my decisions. Then again, I am at the stage in my life where I still have a lot of college debt, so I try to invest as much as I can and pay off my loans as quickly as possible. Even when I do find myself in a situation where my stocks are doing well, I never fool myself into thinking I have more money than I have.
I don't know what exactly causes that, though. I have some friends where the wealth effect definitely takes hold. It is obviously something to do with rationalizing the amount of money you have on paper compared to the amount that you have in reality.
A close family friend is an investor and the other day he was talking about how the wealth effect used to really get to him in the beginning. But now, he's found a way to avoid it.
He said that when he first started investing, he used to watch his portfolio daily and when there was an increase in his portfolio, he would go out and invest again, take out a loan or buy something really expensive, only to watch his portfolio go way down the next day.
He then started to look at the income from his investments rather than investment values. Apparently investment incomes are much more stable and static than the portfolio value is. So there is little to no chance of being misguided by market values and spending money or taking out bank loans.
I'm not very knowledgeable about investing, but my friend's method seems like a good way to get away from the wealth effect and it definitely works for him.
@alisha-- Yes, the opposite happens as well, but that is called "the poverty effect," instead of the wealth effect. It's when people spend less when their wealth (on paper or reality) decreases. It's sometimes also called the "anti-wealth effect" also.
This theory is a little different from the wealth effect though because the consumer response in the poverty effect is even more intense than it is in the wealth effect. When people see a rise in the value of their property and market shares, they do spend more but they tend to not make any long-term assumptions about the market.
In the anti-wealth or poverty effect, when consumers see a decline in value of their property and shares, they feel that the entire economy is declining and will continue to do so. Since they consider themselves to be in a financial crisis, the decline in spending tends to be more sharp in contrast to the rise in spending in the wealth effect.
This makes sense. When I have more money in my bank account, I do spend more so it makes sense for people to do the same when real estate and stock becomes more valuable. I guess the only difference is that this rise in value might be temporary and could go down in the near future. Cash is different because unless you're involved in exchange rates, the value is going to remain the same.
What I would be interested to know is if the opposite happens as well?
When real estate and stock values go down, do people spend less? If they do, I think this would be supportive of the wealth effect theory.
What do you think?
@David09 - A government bailout may be bad fiscal policy, but I can’t argue that it didn’t help some of the beneficiaries. Some of the auto companies that got bailout money did quite well afterwards, at the taxpayers’ expense of course, since we were footing the bill.
It's true that they got wealthy, but we didn’t, not directly anyway. However I think that when American companies succeed we all profit.
Some people think we should have let them go bankrupt but I think we needed to help out the auto companies instead of giving foreign auto companies an unfair advantage.
@nony - If the government really wants to increase consumer wealth (a dubious proposition) then it should let us keep more of our wealth by reducing taxes, not increasing the money supply as the Feds did with so called “quantitative easing.”
All quantitative easing does is that it floods the market with more dollars, leading to inflation. Reduced taxes will enable consumers to keep more of their own money without affecting the valuation of the dollar.
Also, history has proven that when taxes are reduced then revenue to the treasury increases. It’s a win-win proposition. A rising tide lifts all boats.
@allenJo - You’ve described an income effect, not a wealth effect, if I understand the article correctly. The two are related but not quite the same. Wealth is the result of increased valuations in stock or property, not necessarily increased income. People simply feel richer because they see their portfolios rise and so they spend more.
I’ve never spent an iota extra simply based on what my stocks are doing. I agree with the article – stock prices are wealth on paper, not real until you sell them.
I have spent more as a result of selling stocks at a gain, but in those situations I’ve directed the money towards paying down debt. Debt is the real killer of wealth in my opinion. Other than that I’ve never been a conspicuous consumer, as the economists like to dub it.
Well, you know what they say. The more money that you make, the more money that you spend. I tend to believe that this income effect holds true, unfortunately finding truth to it in my own experience.
Whether it holds true for all income levels, I don’t know. I suppose if you are in a really low income bracket and your income increases slightly you might continue to shop at discount stores and stick with the compact cars for your transportation needs.
I’ve never liked spending a lot on transportation personally myself. I spent seven years riding the bus to my workplace downtown, even though I wasn’t exactly poor. I can’t stand downtown traffic.
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