The wealth effect is a psychological phenomenon that causes people to spend more as the value of their assets rises. The premise is that when consumers’ homes or investment portfolios increase in value, they feel more financially secure, so they increase their spending. Conversely, when consumers see the value of their homes or portfolios fall, they tend to spend less. The wealth effect attempts to explain why consumers might change their spending habits even if their income and fixed costs have stayed the same.
Analysts disagree over whether the wealth effect really exists. Proponents say a $1 increase in wealth can increase spending by 2 to 8 cents. Critics say that if there is a wealth effect, the percentage change consumers experience in their wealth results in a much smaller change in their spending habits, which wouldn’t have a meaningful effect on the economy. Critics also say that changes in employment rates, tax rates and household expenses - not changes in wealth - have the biggest effect on consumer spending.