Wealth Effect

What it is

The wealth effect is a behavioral-economic concept that describes how increases in the market value of households’ assets—most commonly housing and investment portfolios—tend to boost consumer confidence and spending. People often feel “richer” when their asset values rise even if their income and fixed expenses remain unchanged, and that perceived increase in wealth can translate into higher consumption.

How it works

• Rising asset values (e.g., during a bull market) increase consumer confidence.
• Higher confidence generally reduces precautionary saving and raises discretionary spending.
• Businesses can respond similarly: rising asset values may encourage increased hiring and capital expenditures.
• The effect can therefore amplify economic growth during booms and contribute to contractions during asset market declines.

Important considerations

• Unrealized gains: Stock and housing price increases are often unrealized (paper gains) until assets are sold, so they do not directly increase disposable income.
• Other factors matter more for consumption for many households: taxes, employment, household expenses, and credit conditions can outweigh asset-value effects.
• The direction of causation is debated: some argue higher spending can drive asset-price appreciation rather than asset gains causing higher spending.

Example

Historical episodes show consumption can remain strong even when taxes or interest rates rise, as long as asset values keep climbing. For example, in 1968 taxes were increased substantially but consumer spending continued to grow alongside rising stock markets, illustrating the psychological power of wealth gains.

Criticism and alternative views

• Causation vs. correlation: Critics contend that the observed relationship between asset prices and consumption may reflect correlated trends rather than a causal wealth effect.
• Pigou Effect: An alternative idea holds that falling prices can increase real purchasing power and consumption, implying different dynamics between price levels and spending.

Housing vs. stock-market effects

Empirical evidence is stronger for a housing wealth effect than for a stock-market wealth effect. Research by Case, Shiller, and Quigley found only weak evidence that stock-market gains raise consumption but stronger evidence that changes in housing wealth affect spending. One extended study (1975–2012) estimated that a housing boom similar to 2001–2005 could raise household spending by about 4.3% over four years, while a crash like 2005–2009 could reduce spending by roughly 3.5%.

Key takeaways

• The wealth effect describes higher consumption resulting from rising asset values via increased consumer confidence.
• Housing wealth shows more consistent links to spending than stock-market wealth.
• The effect is limited by the fact that many asset gains are unrealized and by other forces (taxes, income, employment).
• Debate continues over causality and the magnitude of the effect.

Selected research

• Case, K. E., Shiller, R., & Quigley, J., “Comparing Wealth Effects: The Stock Market Versus the Housing Market,” NBER Working Paper 8606 (2001).
• Case, K. E., Shiller, R., & others, “Wealth Effects Revisited: 1975–2012,” NBER Working Paper 18667 (2013).