Thewealth effect is the change in spending that accompanies a change in perceivedwealth.[1]Usually the wealth effect is positive: spending changes in the same direction as perceived wealth.
Changes in aconsumer's wealth cause changes in the amounts and distribution of his or herconsumption. People typically spend more overall when one of two things is true: when peopleactually are richer, objectively, or when peopleperceive themselves to be richer—for example, the assessed value of theirhome increases, or astock they own goes up in price.
Demand for some goods (calledinferior goods) decreases with increasing wealth. For example, consider consumption of cheap fast food versus steak. As someone becomes wealthier, their demand for cheap fast food is likely to decrease, and their demand for more expensive steak may increase.
Consumption may be tied to relative wealth. Particularly when supply is highly inelastic, or when the seller is a monopoly, one's ability to purchase a good may be highly related to one's relative wealth in the economy. Consider for examplethe cost of real estate in a city with high average wealth (for example New York or London), in comparison to a citywith a low average wealth. Supply is fairly inelastic, so if ahelicopter drop (orgold rush) were to suddenlycreate large amounts of wealth in the low wealth city, those who did not receive this new wealth would rapidly findthemselves crowded out of such markets, and materially worse off in terms of their ability to consume/purchase real estate(despite having participated in a weakPareto improvement). In such situations, one cannot dismiss the relative effect ofwealth on demand and supply, and cannot assume that these are static (see alsoGeneral equilibrium).
However, according toDavid Backus the wealth effect is not observable in economic data, at least in regard to increases or decreases in home or stock equity.[2] For example, while thestock market boom in the late 1990s (caused by thedot-com bubble) increased the wealth of Americans, it did not produce a significant change in consumption, and after the crash, consumption did not decrease.[2]
EconomistDean Baker disagrees and says that “housing wealth effect” is well-known and is a standard part of economic theory and modeling, and that economists expect households to consume based on their wealth. He cites approvingly research done by Carroll and Zhou that estimates that households increase their annual consumption by 6 cents for every additional dollar of home equity.[3]
Inmacroeconomics, a rise inreal wealth increases consumption, shifting theIS curve out to the right, thus pushing up interest rates and increasingaggregate demand. A decrease in real wealth does the opposite.