Wealth Effect
The wealth effect is the change in consumption that results from a change in the value of household wealth, such as housing, equities, and other assets. When asset prices rise, households feel wealthier and tend to increase spending, and when asset prices fall, they reduce spending. The wealth effect is a channel through which asset price movements affect aggregate demand, and it is central to the analysis of the transmission of monetary policy and of the effects of financial market fluctuations on the economy.
The mechanism
The wealth effect operates through the household budget constraint. Wealth is a source of resources that can be used for consumption, and a change in wealth changes the resources available over the lifetime. Even if the change in wealth is not realised through a sale, households may adjust their spending in response to the change in the value of their assets, because the wealth forms part of their permanent income and affects their sense of financial security.
The size of the effect depends on the distribution of wealth, on the extent to which the change is perceived as permanent, and on the response of consumption to wealth. Because wealth is highly concentrated, the effect on aggregate consumption depends on the spending behaviour of wealthy households, which may differ from that of the population as a whole. Changes that are perceived as temporary have smaller effects than those perceived as permanent.
Housing and financial wealth
The wealth effect operates through different types of wealth, each with distinct characteristics. Housing wealth is widely held and its value is directly observable, and changes in house prices affect the spending of homeowners through the wealth effect and through the availability of credit, since higher house prices increase the collateral available for borrowing. Financial wealth, including equities and bonds, is more concentrated, and changes in its value affect spending mainly through the behaviour of wealthier households.
The composition of wealth matters for the transmission of shocks. In economies where housing is a large share of household wealth, changes in house prices have a large effect on consumption, and the economy is more sensitive to developments in the housing market. In economies where financial assets dominate, the effect operates mainly through equity prices, which are more volatile, and the effect may be smaller in aggregate because of the concentration of financial wealth.
Monetary policy transmission
The wealth effect is one of the channels through which monetary policy affects the economy. When the central bank lowers interest rates, asset prices tend to rise, both because lower rates raise the present value of future income and because they encourage investment and risk-taking. The increase in asset prices raises household wealth, which supports consumption, adding to the stimulus from lower rates. Conversely, higher rates reduce asset prices and wealth, dampening demand.
The strength of this channel varies across economies and over time. It is stronger where households hold substantial assets and where they are able to borrow against them, and weaker where saving is low and credit is limited. The channel also depends on the response of asset prices to changes in interest rates, which can be affected by risk premia and by expectations, and it is monitored by central banks as part of the assessment of the transmission of policy.
Applications and considerations
The wealth effect is relevant to the analysis of financial cycles, of the effects of asset price bubbles, and of the distributional consequences of asset price movements. The rise in asset prices before a financial crisis can support consumption and create a sense of prosperity, while the fall after the crisis can depress spending and deepen the downturn, as households and firms reduce debt and rebuild their balance sheets.
The distributional effects are significant. Since wealth is concentrated, gains from asset price increases accrue disproportionately to wealthier households, while losses may fall on those who borrowed to buy assets. The effect on aggregate demand therefore depends on the distribution of wealth and on the spending behaviour of different groups, and the analysis of the wealth effect must consider these distributional dimensions alongside the aggregate effects.
Heterogeneity and distribution
The wealth effect varies across households according to their wealth and their response to changes in it. Wealthy households, which hold most of the wealth, account for most of the effect in aggregate, but their marginal propensity to consume out of wealth may be lower than that of less wealthy households, which have less wealth but a higher propensity to spend. The net effect depends on the distribution of wealth and on the spending behaviour of different groups.
The heterogeneity matters for the analysis of policy and of shocks. If the wealth effect is concentrated among households with a low propensity to consume, the aggregate effect may be small, while if it extends to households with a high propensity, the effect may be larger. The distribution of wealth and the behaviour of different groups are therefore central to understanding the transmission of asset price changes to demand.
Housing wealth and credit
Housing wealth has a distinctive role in the wealth effect, because it is widely held and because it can be used as collateral for borrowing. Rising house prices increase the value of homeowners' wealth and the collateral available to them, supporting consumption both through the wealth effect and through increased access to credit. The effect is particularly strong where mortgage markets are developed and where homeowners can borrow against the equity in their homes.
Falling house prices have the opposite effect, reducing wealth and collateral and depressing consumption, and the effect can be amplified by the response of credit. The interaction between housing wealth, credit, and consumption is central to the analysis of financial cycles, and it explains why housing market developments have such large effects on the economy. The strength of the effect depends on the structure of the mortgage market and on the regulation of borrowing.
Measurement
Measuring the wealth effect requires estimates of the response of consumption to changes in wealth, holding other influences constant. The estimates are derived from data on consumption and wealth over time and across households, and they are used to calibrate models of the economy. The estimates vary widely, and they are uncertain, because wealth and consumption are affected by common factors and because the response operates over time.
The measurement is complicated by the distinction between changes in wealth that are permanent and those that are temporary, and by the effects of expectations. A change in asset prices that is expected to persist has a larger effect on consumption than one that is expected to reverse. The measurement also faces the problem of identifying the causal effect, since asset prices and consumption respond to common shocks, and analysts use a variety of methods to address the problem.
Policy implications
The wealth effect has implications for monetary policy and for financial regulation. It means that asset purchases by the central bank affect the economy partly through their effect on asset prices and wealth, in addition to their effect on interest rates. It also means that the transmission of policy depends on the distribution of wealth and on the response of households to changes in it, and that the effectiveness of policy varies across economies.
The wealth effect also informs the assessment of financial stability. The build-up of wealth during booms can support consumption and create a sense of prosperity, while the fall during busts can depress demand and deepen the downturn. Understanding the wealth effect, and the role of credit and of expectations in it, is therefore central to the analysis of financial cycles and to the design of policies that limit the build-up of vulnerabilities and that support the economy during downturns.