Wealth Effect

Publication Date :

20 Dec, 2023

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Table Of Contents

What Is The Wealth Effect?

The wealth effect refers to the behavioral economic theory stating that individuals change their spending habits by changing the prices of their assets, and their views on their perceived wealth. The wealth effect theory shows that as the price of an asset increases, the security related to the asset increases, and the buying habit positively increases consumer spending.

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.

What Is The Wealth Effect?

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 macroeconomics 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 ,more lavish spending causes asset appreciation, not vice versa, and the effect is more of a correlation function than causality.

Impacts

The wealth effect theory has a specific 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 perceptions of wealth increase.
Banks become more inclined to provide mortgage loans.
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 were raised.

Examples

Now that we understand the basics and a certain degree of intricacies of the wealth effect macroeconomics, let us also understand the concept’s practicality through the examples below.

Example #1

Nikita, a homeowner in a suburban neighborhood. Over the past few years, the real estate market in her area has experienced a significant upswing, leading to a considerable increase in the value of her home. This surge in home value has triggered the wealth effect in Nikita’s financial mindset.

Excited about the perceived increase in her wealth, she decides to embark on a home improvement project she had postponed for a while. She hires contractors to remodel her kitchen, invests in high-quality appliances, and even decides to upgrade her landscaping. Nikita's spending spree goes beyond the home improvements; she indulges in purchasing a new car and takes a dream vacation with her family.

Her actions exemplify the wealth effect in a practical situation. The rise in her home's value acts as a psychological boost, making her feel wealthier and more financially secure. This, in turn, prompts her to increase her discretionary spending on non-essential items and experiences. In this case, the wealth effect not only influences her personal financial decisions but also contributes to the stimulation of economic activities, benefiting contractors, retailers, and the overall economy.

Example #2

As per FRED's 2022 data depicted in the chart below, it has been 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.

How To Manage It Effectively?

Effectively managing the wealth effect theory involves a balanced approach that combines financial education, strategic planning, and disciplined financial habits. Let us understand how through the points below.

Prioritize financial literacy and education to ensure a clear understanding of the wealth effect and its potential impact on spending habits.
Diversify investments to mitigate the impact of market fluctuations on overall wealth. This helps in avoiding overreliance on a single asset, such as home equity.
Adopt a long-term perspective in financial planning. Recognize that short-term market fluctuations may not accurately reflect overall financial well-being.
Establish and maintain an emergency fund to provide a financial cushion during economic downturns, reducing the need to make impulsive financial decisions.
Implement a comprehensive budget that considers both short-term and long-term financial goals. This ensures a disciplined approach to spending and saving.
Seek guidance from financial professionals to develop a personalized wealth management strategy that aligns with individual financial objectives.
Exercise caution in taking on excessive debt during periods of perceived wealth. Avoid accumulating debt that may become burdensome during economic downturns.
Regularly review and reassess financial goals, adjusting strategies as needed to align with changing economic conditions and personal circumstances.

Wealth Effect vs Income Effect

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

Wealth Effect	Income Effect
It reflects the change in the value of the security or asset consumers own.	It reflects the real change in the income of the consumers.
Under its effect, only the perception of wealth increases takes place.	Under its effect, purchasing power increases a great deal.
The value of the security or the asset increases positively.	The real income of the consumers increases positively.
Security of wealth created by the price rise of assets leads to their holders increasing their spending on goods.	Increasing income creates more purchasing power for goods at the same or little level despite rising prices.
It may or may not exhibit its effects on a nation’s economy.	It often reflects economic growth and government tax cuts.
It bolsters only a certain population with an asset or security portfolio investment.	It affects the entire population positively, whether they have any asset or security investment.
It does not affect the production sector or service sector	Due to the wealth effect on aggregate demand entire production and service sector gets affected by the rising demand out of increased spending power from rising incomes.
It only affects security markets, the job market, and the real estate sector.	It affects all such sectors and all other sectors too.

Frequently Asked Questions (FAQs)

What is the real wealth effect?

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.

What does wealth effect do?

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.

How can one measure wealth effect?

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.

What do you mean by wealth effect in economics?

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.