Wealth effect

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In economics, the wealth effect is an increase in spending that accompanies an increase in wealth (in absolute terms), or merely a perceived increase in wealth (in relative terms).

1 Effect on individuals
2 Effect on government
3 See also
4 External links

[edit] Effect on individuals

The effect includes the changes in the amounts and composition of consumer consumption caused by changes in consumer wealth. Economists believe people spend more when one of two things is true: when people actually are richer (by objective measurement, for example, a bonus or a pay raise at work, which would be an income effect), or when people perceive themselves to be "richer" (for example, the assessed value of their home increases, or a stock they own has gone up in price recently). Economists also believe that this situation has macroeconomic implications. A typical response to the wealth effect includes a reduced supply of labor; however, personal income will still be increased. This can be seen by the parallel outward shift in the production function, which is indicative of the wealth effect. The effect's size is governed by a different calculation in either case.

[edit] Effect on government

Recent decades' disillusionment with fiscal policy as a macroeconomy management tool and growing concerns over public debt have led some analysts to characterize government borrowing and spending behavior as a "wealth effect." The relative low cost of government borrowing given the equity premium puzzle allows for the decoupling of current government spending from current government taxation. This decoupling means that current taxpayers do not bear the full cost of current government spending. Hence, government taxes can be lowered and spending can be raised independent of each other, removing the cost/benefit analysis discipline that would be enforced on both taxes and spending if they remained fully connected in the present.

This dynamic seems to be at play in the United States in the early 21st century. The high rate of savings in Asian countries and those savers' apparent concerns over the risks of placing that savings in Asian banks and Asian investments have led to much of that money flowing to the U.S. government in the form of bond purchases. The strong flow of Asian money into U.S. government securities appears to be offsetting any upward interest rate pressure that would be expected to result from increased U.S. government borrowing and worrisome Social Security and Medicare unfunded liabilities.