In theory, a widespread increase in disposable income leads to increases in stock valuations and, therefore, increases the overall value of the stock market. Disposable income is defined as the total amount of household income that's available for spending and saving after paying income taxes.

Key Takeaways

  • A widespread increase in disposable income leads to increases in stock valuations and, therefore, increases the overall value of the stock market.
  • When disposable income increases, households have more money to either save or spend, which naturally leads to a growth in consumption.
  • Consumer spending is one of the most important determinants of demand; it makes up almost 70% of the total United States gross domestic product (GDP).

When disposable income increases, households have more money to either save or spend, which naturally leads to a growth in consumption. Consumer spending is one of the most important determinants of demand; it creates the demand that keeps companies profitable and hiring new workers. Consumer spending makes up almost 70% of the total United States gross domestic product (GDP). In 2019, that was $13.28 trillion.

If manufacturers ramp up their production to meet demand, they create more jobs. When workers' wages rise, this also creates more spending. An increase in consumption can increase corporate sales and corporate earnings, thus increasing the value of individual stocks. This increase in individual share price valuations could then lead to a market-wide increase in value. This has the potential to create an economic boom.

The opposite also holds true. If disposable income decreases, households have less money to spend and save, which then forces consumers to consume less and become more frugal. This decrease in consumption could then decrease corporate sales and corporate earnings, decreasing the value of individual stocks. This decrease in individual share price valuations could then lead to a market-wide decrease in value. This potentially leads to depression or recession.

Increases in disposable income don't always result in an increase in the value of the stock market, and vice versa. Sometimes, especially in the wake of a recession and during a recovery period, although disposable income increases, many consumers remain frugal and do not use their increase in disposable income to increase consumption. When this occurs, even an increase in disposable income can lead to a recession. So, an increase in disposable income doesn't necessarily lead to economic expansion or growth in the stock market.

Consumer confidence is a statistical measure of consumers' feelings about current and future economic conditions. When consumer confidence is low, people tend to save their money, rather than spend it, and this can actually constrain economic growth.