The wealth effect is an economic term, referring to an increase (decrease) in spending that accompanies an increase (decrease) in perceived wealth.
Effect on individuals
The effect would cause changes in the amounts and distribution of consumer consumption caused by changes in consumer wealth. People should spend more when one of two things is true: when people actually are richer, objectively, or when people perceive themselves to be richer—for example, the assessed value of their home increases, or a stock they own goes up in price.
Demand for some goods (especially Inferior goods) typically 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 in the case of monopoly—one's ability to purchase a good may be highly related to one's relative wealth in the economy. Consider for example the cost of real estate in a city with high average wealth (for example New York or London), in comparison to a city with a low average wealth. Supply is fairly inelastic, so if a helicopter drop (or gold rush) were to suddenly create large amounts of wealth in the low wealth city, those who did not receive this new wealth would rapidly find themselves crowded out of such markets, and materially worse off in terms of their ability to consume/purchase real estate (despite having participated in a weak Pareto improvement). In such situations, one cannot dismiss the relative effect of wealth on demand and supply, and cannot assume that these are static (see also General equilibrium).
However, according to David Backus, a NYU economist, the wealth effect is not observable in economic data, at least in regards to increases or decreases in home or stock equity. For example, while the stock market boom in the late 1990s (q.v. dot-com bubble) increased the wealth of Americans, it did not produce a significant change in consumption, and after the crash, consumption did not decrease.
Economist Dean 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.
The wealth effect and the Paradox of Thrift are contradictory. The paradox assumes that people will spend when they feel wealthy, based on the wealth effect, but not when they are actually more wealthy.
- • Darby, Michael R. (1987). "wealth effect," The New Palgrave: A Dictionary of Economics, v. 4, pp. 883–4.
• Jelveh, Zubin. "In Praise of the Wealth Effect – Economics Blog – Zubin Jelveh – Odd Numbers – Portfolio.com". portfolio.com. Retrieved 2009-04-20.
- Flavelle, Christopher (2008-06-10). "Debunking the "Wealth Effect": Declining house prices don't necessarily slow down consumer spending.". Slate.
- Dean, Baker (2011), The End of Loser Liberalism, Center for Economic and Policy Research, p. 18, ISBN 978-0-615-53349-0