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The Wealth Effect by Jordan at Investing Blog

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The wealth effect is a very commonly referenced term under the umbrella of Keynesian economic thought where perceived increases in the amount of available wealth increases spending and consumption, two positive short-run consequences. Most recently, Ben Bernanke cited the wealth effect for the second round of quantitative easing of $600 billion in cash.

The most important part of the wealth effect is how it affects consumer spending and consumption. Since the economic output of the United States is 70% consumption, the most retail changes in spending (those that happen at the household level) carry more weight than anything at the corporate or public levels. The idea is simply that consumers spend more when they believe they are richer. Two common avenues for the expansion in wealth are real estate and stock prices.

Feeling Wealthier

Feeling wealthier most commonly leads to lifestyle inflation, an effect of rising incomes or perceived wealth where we either consume more, or consume more valuable products. For instance, to those who have recently become wealthy, a peanut butter and jelly sandwich costing only $.50 looks a lot less exciting than a $50 steak and potato dinner. While that example showcases the idea, not all lifestyle inflation has to happen to that extreme. We may substitute generic products for brand name, or maybe add features to a car that we wouldn’t have ordinarily purchased.

Arguing the Point

Economists have for a long time argued whether or not the wealth effect actually affected spending habits at all, or if increases in some asset values were more important than others. Real estate, for example, might generate greater increases in consumption since home prices are more easily borrowed against than stock prices.

What economists have yet to disagree on is whether or not a it affects consumer confidence. Increases in perceived wealth can create an increase in consumer confidence numbers, however the difference between reported confidence to a pollster and measurable change in spending habits are far different.

About Jordan

Jordan is the web master of www.investingblog.org, a site dedicated to skillful investing, news and recent trends. You can read the original article here.

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