Wealth effect

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The wealth effect is an economic term, referring to 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 References
5 External links

[edit] Effect on individuals

The effect would cause changes in the amounts and composition 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 (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). Such a situation would have macroeconomic implications, such as a reduced supply of labor; however, personal income would still be increased. This would be seen by the parallel outward shift in the production function, which would be indicative of the wealth effect. The effect's size would be governed by a different calculation in either case.

However, the idea of a wealth effect on individuals doesn't stand up to economic data.^[1] For example, the stock market boom in the late 1990s (q.v. dot-com bubble) increased the wealth of Americans, but it didn't produce a significant change in consumption. Afterwards, consumption did not decrease.^[1]

[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. (See national debt.)