Wealth effect
Encyclopedia
The wealth effect is an economic term, referring to an increase (decrease) in spending that accompanies an increase (decrease) in perceived wealth.
consumption
caused by changes in consumer wealth
. People should spend more when one of two things is true: when people actually are richer, objectively, or when people perceive themselves to be richer—for example, the assessed value of their home increases
, or a stock
they own goes up in price.
Demand for some goods (especially Inferior good
s) typically decreases with increasing wealth. For example, consider consumption of cheap fast food versus steak. As someone becomes wealthier, their demand for cheap fast food is likely to decrease, and their demand for more expensive steak may increase.
Consumption may be tied to relative wealth. Particularly when supply is highly inelastic - or in the case of monopoly -
one's ability to purchase a good may be highly related to one's relative wealth in the economy. Consider for example
the cost of real estate in a city with high average wealth (for example New York or London), in comparison to a city
with a low average wealth. Supply is fairly inelastic, so if a helicopter drop (or gold rush
) were to suddenly
create large amounts of wealth in the low wealth city, those who did not receive this new wealth would rapidly find
themselves crowded out of such markets, and materially worse off in terms of their ability to consume/purchase real estate
(despite having participated in a weak Pareto improvement). In such situations, one cannot dismiss the relative effect of
wealth on demand and supply, and cannot assume that these are static. (see also General equilibrium
).
However, according to David Backus, an NYU economist, the wealth effect is not observable in economic data, at least in regards to increases or decreases in home or stock equity. For example, while the stock market boom in the late 1990s (q.v. dot-com bubble
) increased the wealth of Americans, it did not produce a significant change in consumption, and after the crash, consumption did not decrease.
Effect on individuals
The effect would cause changes in the amounts and distribution of consumerConsumer
Consumer is a broad label for any individuals or households that use goods generated within the economy. The concept of a consumer occurs in different contexts, so that the usage and significance of the term may vary.-Economics and marketing:...
consumption
Consumption (economics)
Consumption is a common concept in economics, and gives rise to derived concepts such as consumer debt. Generally, consumption is defined in part by comparison to production. But the precise definition can vary because different schools of economists define production quite differently...
caused by changes in consumer wealth
Wealth
Wealth is the abundance of valuable resources or material possessions. The word wealth is derived from the old English wela, which is from an Indo-European word stem...
. People should spend more when one of two things is true: when people actually are richer, objectively, or when people perceive themselves to be richer—for example, the assessed value of their home increases
Real estate pricing
Real estate pricing deals with the valuation of real estate and all the standard methods of determining the price of fixed assets apply....
, or a stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
they own goes up in price.
Demand for some goods (especially Inferior good
Inferior good
In consumer theory, an inferior good is a good that decreases in demand when consumer income rises, unlike normal goods, for which the opposite is observed. Normal goods are those for which consumers' demand increases when their income increases....
s) typically decreases with increasing wealth. For example, consider consumption of cheap fast food versus steak. As someone becomes wealthier, their demand for cheap fast food is likely to decrease, and their demand for more expensive steak may increase.
Consumption may be tied to relative wealth. Particularly when supply is highly inelastic - or in the case of monopoly -
one's ability to purchase a good may be highly related to one's relative wealth in the economy. Consider for example
the cost of real estate in a city with high average wealth (for example New York or London), in comparison to a city
with a low average wealth. Supply is fairly inelastic, so if a helicopter drop (or gold rush
Gold rush
A gold rush is a period of feverish migration of workers to an area that has had a dramatic discovery of gold. Major gold rushes took place in the 19th century in Australia, Brazil, Canada, South Africa, and the United States, while smaller gold rushes took place elsewhere.In the 19th and early...
) were to suddenly
create large amounts of wealth in the low wealth city, those who did not receive this new wealth would rapidly find
themselves crowded out of such markets, and materially worse off in terms of their ability to consume/purchase real estate
(despite having participated in a weak Pareto improvement). In such situations, one cannot dismiss the relative effect of
wealth on demand and supply, and cannot assume that these are static. (see also General equilibrium
General equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...
).
However, according to David Backus, an NYU economist, the wealth effect is not observable in economic data, at least in regards to increases or decreases in home or stock equity. For example, while the stock market boom in the late 1990s (q.v. dot-com bubble
Dot-com bubble
The dot-com bubble was a speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the more...
) increased the wealth of Americans, it did not produce a significant change in consumption, and after the crash, consumption did not decrease.
See also
- Wealth elasticity of demandWealth elasticity of demandWealth elasticity of demand in microeconomics is the proportional change in the consumption of a good relative to a change in consumers' wealth...
- Income elasticity of demand
- Wealth (economics)
- Ricardian equivalenceRicardian equivalenceThe Ricardian equivalence proposition is an economic theory holding that consumers internalize the government's budget constraint: as a result, the timing of any tax change does not affect their change in spending...