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.