What is 'The Wealth Effect'

The wealth effect is the premise that when the value of stock portfolios rises due to escalating stock prices, investors feel more comfortable and secure about their wealth, causing them to spend more. For example, economists in 1968 were baffled when a 10% tax hike failed to slow down consumer spending. Later this continued spending was attributed to the wealth effect; while disposable income fell as a result of increased taxes, wealth rose sharply as the stock market moved up. Undaunted, consumers continued their spending spree.

BREAKING DOWN 'The Wealth Effect'

The wealth effect helps to power economies during bull markets. Big gains in people's portfolios can make them feel more secure about their wealth and their spending. However, the relationship between spending and stock market performance is a double-edged sword as poor stock prices in bear markets hurt economic confidence.

The wealth effect refers to the psychological effect of asset value increases, such as those experienced during a bull market, on spending patterns. The concept focuses on how the feelings of security, referred to as consumer confidence, bolstered by the rising value of assets, such as investment portfolios and real estate, lead to higher levels of spending, correlating with lower levels of saving. These changes are said to be seen regardless of changes in discretionary income, in either a positive or negative direction.

The theory can be applied to both business and personal spending. Suggested increases in hiring and capital expenses increase as businesses become more secure in a similar fashion to that observed on the consumer side.

Rising Portfolio Value

A rise in the value of a person’s portfolio does not actually lead to higher disposable income. Initially, stock market gains must be considered unrealized, as they are still tied to the investments, which is not the same as increases in regular income.

Accuracy of the Wealth Effect Theory

There is significant debate regarding the existence of the wealth effect, specifically as it relates to the stock market. Some liken the effect to correlation and not causation, suggesting increased spending leads to asset appreciation and not the other way around. Additionally, the wealth effect does not account for the impact of anticipated increases in future income.

Even though it is still not definitively connected, there is stronger evidence that relates to increases in home values and increased spending. Increased spending can be spurred by lower interest rates and easier access to credit, especially in areas such as the housing market. Increases in home sales lead to rising home values as demand outweighs supply.

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