The wealth effect is the assumption that consumers naturally prefer to spend more, even when wide-held investments such as stocks and real estate are increasing in value. For this reason, the theory that the wealth effect encourages consumer spending makes perfect sense intuitively. However, empirical evidence does not support this conclusion. To understand why, we will examine several competing theories on the wealth effect and explore how they fit into a more comprehensive explanation of consumer spending.
One of the most important factors in determining spending behavior is a significant interest rate. Consumers with high disposable income tend to be more likely to use credit cards and other debt-based alternatives to raising funds for purchases. Credit cards also have the added advantage of often offering substantial interest-free periods in which consumers can pay no interest charges on balance transfers or purchases. Thus, high interest credit card balances can be used as an opportunity to increase spending. If, however, a significant interest rate is charged on a card that limits purchases to cash purchases, consumers are likely to limit their use of credit cards and thus their use of debt to finance purchases.
In addition to the direct wealth effect, another widely cited theory concerning the wealth effect relates it to the performance of the housing market. The housing market, after all, has been characterized by an unusually high level of disposable income for homeowners. Homeowners are thus in a strong position to take advantage of lower interest rates associated with rising home prices. As a result of this, home buyers are able to absorb some of the effects of lower real estate values more successfully. By extension, homeowners may also be minimizing the effects of the wealth effect on spending when they refinance their existing mortgages to take advantage of historically low interest rates.
A related theory regarding the wealth effect relates it to the duration of time that buyers spend in investing. It is well-known that investors are sensitive to the duration of time before they sell their investments, especially with bull markets. According to this theory, people who invest during bull markets are able to absorb a greater portion of gains from their investments than people who do not. In other words, they are taking advantage of the rising prices by increasing their net worth more quickly. As a result of this, they are likely to have a larger and more secure wealth effect on household spending.
Another aspect of the wealth effect speculates that people are using their spare income to purchase items that are expensive. In other words, they are using their wealth to invest in things that will help them secure their future. The logic behind this line of thinking is that if someone is earning a large income but is spending most of it on living expenses such as rent or car payments, then the money could be spent on a more lucrative investment. If money is being saved for the uncertain future, it is expected that future income will be higher and thus people are willing to pay more for stocks, bonds, and other potentially safe investments.
There is also another aspect of the wealth effect that suggests that people are using their disposable income to purchase stock market shares. If they earn a significant interest rate on their investments pay off handsomely, they may decide to cash in their shares for a greater gain. The logic here is that people would be willing to pay more for more potential when they know they will receive a significant return on their investment.
Some experts believe that the wealth effect takes into account both positive and negative aspects of household wealth creation. Those who are actively creating household wealth tend to act in a way that boosts the economy. On the other hand, households who are passively creating household wealth tend to act in a way that lowers the economy. These households would benefit from having lower spending.
Regardless of these theories, the truth is that household wealth creation is influenced by spending and saving attitudes. Typically, people save money during positive wealth effect periods and spend the money during negative wealth effect periods. Therefore, those who are active in creating wealth tend to act in a way that boosts the economy. On the other hand, households that passively create household wealth tend to act in a way that reduces the economy. These households would benefit from lower spending.