It's Supposed to be a Two-Edged Sword
Subject Wealth Effect
Topic Aggregate Demand/Aggregate Supply
Key Words Wealth Effect, Disposable Income, Interest Rates, Consumption
News Story

Consumer expenditures account for two-thirds of total spending. Among the factors that affect consumer spending are personal income, expectations, price levels, credit availability and wealth. The "wealth effect" describes the change in consumption resulting from a change in wealth. When stock prices were rising, economists attributed a portion of the increase in consumption to the wealth effect. Now that stock prices have fallen, economists are wondering why the decrease in wealth has not significantly reduced consumer spending.

Consumers spend an additional four cents for every dollar of new wealth. Trillions of dollars have been lost as a result of stock price declines. Applying this percentage to the lost wealth should have caused an observable decrease in consumption. It did not. There are a number of reasons being offered as to why the decrease did not materialize.

First and foremost has been the significant gain in income. For the year ending June 2002, personal income had risen 3.4 percent. Pension income and other government transfers grew 10 percent. Inflation-adjusted disposable income grew at an annualized rate of 9.1 percent for the first half of 2002 - one of the fastest growth rates in two decades. Low interest rates, especially for mortgages, low inflation and reduced income tax burdens are responsible for this gain.

Another factor reducing the impact of lowered stock prices has been the increase in housing prices. According to an International Monetary Fund study, decreased asset values should have lowered consumer spending 1.9 percent, however, increased housing prices would have raised spending 1.6 percent.

It is not certain whether income gains will continue in the coming months. In addition to concerns about the continued weakness of the economy, higher oil prices, another terrorist attack, or additional declines in asset values could reduce income, and therefore spending. In response to some of the uncertainty about the future course of the economy, the personal savings rate has been rising. Increased saving necessarily means reduced spending and this could have further repercussions on the economy.

(Updated September 1, 2002)

1. Explain the difference between personal income and disposable income. How can personal income increase by a lower amount than disposable income?

What is the wealth effect? How does an increase in wealth affect aggregate demand?


Explain how a decrease in income taxes could offset the negative impact of reduced wealth on total spending?

Source Bernard Wysocki Jr., "Forget the Wealth Effect: Income Drives Consuemr Spending," The Wall Street Journal, August 12, 2002.

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