What Is The Wealth Effect?

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The increased spending happens irrespective of growth or decline in income. A company hires more, security traders buy more, and consumers buy more properties due to the wealth effect. It is attributed to the psychological effect of consumers feeling wealthy when their asset prices increase. Unfortunately, the effect has yet to be proved empirically but prevails as an unverified concept, having gone wrong many times.

Key Takeaways

  • The wealth effect occurs when a person feels that their asset value has increased and starts spending more irrespective of whether the income has increased.It leads to a change in perception regarding a person’s wealth security, leading to increased spending on other products without experiencing real income growth.It differs from the income effect in the sense that only perception regarding wealth changes of the asset holders due to the Wealth-Effect. In contrast, the income effect increases income and purchasing power and affects all persons with or without assets.This effect has been a mere psychological concept that has not been proved empirically until 2022.

Wealth Effect Explained

The wealth effect is a false sense of wealth security to the holders of assets and securities when their prices increase, leading to increased consumption and spending. In a way, it positively impacts the psychology of asset-holding consumers. Hence, their sense of money security gets boosted when the securities and assets show value improvement. It leads to an enhanced willingness to spend, increased borrowers against the house, and a rise in income through rents, interest, and dividends. In short, consumers spend more and save less.

Many life cycle theories have tried to explain the wealth effect management on consumer spending. For example, some say that the consumption of households gets smoothened during a lifecycle. Hence, any wealth change directly impacts these consumers’ average level of spending. In this case, consumers with assets conflate their enhanced wealth and total income, forcing them to spend more on buying unnecessary luxury items with their money.

Businesses can use the wealth effect economic theory as well. As observed on the consumer side, businesses often increase their employment rates and capital expenditures in response to growing asset prices. According to this, economic growth should rise during bull markets and fall during bear ones.

Still, much disagreement exists among market experts regarding whether the wealth impact exists, particularly in the stock market. Some contend that greater spending causes asset appreciation, not vice versa, and the effect is more a correlation function than causality.

Impacts

This concept has a certain positive and negative wealth effect on consumers, but the positive outweighs the negative impacts as below:

  • Greater wealth leads to higher interest, dividend, or rent incomes.Mortgage equity withdrawal and remortgage become easier.The only negative impact visible is a decreased ratio of savings concerning the disposable income of consumers due to false wealth increase perception.Banks get more inclined to provide a mortgage loan.The government gets more tax collections and increases its revenue.

The period when the asset price and securities portfolio increase has often got termed a bull-market period. The Wealth-Effect matters the most because consumer spending was not impacted badly during the bull markets when the taxes and interest rates got raised.

Example

Let us go through a wealth effect example to understand the concept better.

As per FRED’s 2022 data depicted in the chart below, it has got observed that during the coronavirus:

  • Household net worth, including home values, security holdings, and 401K holdings, has skyrocketed 86% from $56 trillion (T) in 1st quarter of 2009 to $104T for 1st quarter of 2020 and to $141T in 1st quarter of 2022. That is a 36% rise.The net-worth increase has resulted from increasing the savings, asset value, and asset prices of those with it.Those who do not own assets, security portfolios, or savings have suffered the poverty effect.

Therefore, a noticeable increase of $37T observed during the coronavirus amounts to one-half times the annual Gross Domestic Product (GDP) of $24T. The increase of 37T dollars in consumer net worth has created a huge wealth effect leading to an increase in spending, although it lacks a real increase in income.

Wealth Effect vs Income Effect

Let us go through the differences between the wealth effect vs income effect using a comparative table below:

This article has been a guide to what is the Wealth Effect. Here, we explain it in detail with its impacts and an example and compare it with the income effect. You may also find some useful articles here –

The real wealth effect arises when changes in the price level create changes in consumer spending because different assets have different buying power. So if prices drop, your money will instantly be able to purchase more goods, giving you the impression that you are wealthy and making more purchases.

It helps one to successfully explain the psychological concept of people feeling their wealth increases when their assets or security values increase. However, there may not be any increase in the customer’s income level or purchasing power.

Researchers measure the effect by using the geographic variation within the stock market holding of the United States. Then, they determine every country’s stock market wealth by employing anonymized data of dividend income from tax returns.

In economics, such effects mean that the value increase in household assets and securities creates a false sense of wealth security. As a result, they start spending more with the same old income.

  • Trickle-Down EffectWealth Accumulation Wealth