What is The Wealth Effect?

What is The Wealth Effect?


Welcome to the Investors Trading Academy talking
glossary of financial terms and events. Our word of the day is “Wealth effect”
As people get wealthier, they consume more. This wealth effect has important consequences
for monetary policy. When there is an interest rate increase, future income from assets such
as equities must be discounted at a higher rate than before. As a result, their owners
feel poorer and spend less. A cut in interest rates has the opposite effect. Economists
disagree on the wealth elasticity of consumption: how much consumer spending would rise if wealth
increased by, say, 1%. Different consumers may have different wealth elasticity. If most
of the increase in wealth goes to poorer people, this may have a different wealth effect than
if most of it went to people who are already wealthy. The source of the wealth increase
may also matter. If share prices rise or interest rates fall, consumers may be slow to spend
out of their increased wealth if they think the increase may be temporary. However, if
they think a sharp rise in share prices is permanent and the stock market then tumbles,
the result may be that consumption falls by enough to cause a recession. The wealth effect
of rising house prices is particularly uncertain.

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