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.

By Barry Norman, Investors Trading Academy – ITA