South-Western College Publishing - Economics  
The Bulls and Their Bounty
Subject Consumption, Aggregate Expenditure, Keynesian Model
Topic Employment, Unemployment, and Inflation
Key Words Wealth Effect, Consumption, Savings
News Story The stock market, as everyone knows, has experienced unprecedented growth. For the 1995-1997 period the US had the largest inflation-adjusted gain in stock prices of the industrialized nations. Last year’s gain alone was 28.4 percent. This increase has created much wealth?about $9 trillion over the last 10 years?and consumers have been spending some of this accumulation. In recent months, the fall in stock market prices has created some anxiety that a reversal of this process could significantly slow the economy.

Macroeconomic Advisors, a St. Louis forecasting firm, has recently estimated the relationship between gains in stock market wealth and increased consumer spending. They found that a third of last year’s 3.6 percent increase in inflation-adjusted consumer spending could be attributable to this wealth effect. From 1995 to 1997 about 30 percent of the increase in consumer spending was the result of stock market gains. Other studies have reported similar impacts in Japan, Germany, and Britain. It should be noted that increased spending reduces measured savings since stock market gains are not included as a part of current income.

The wealth effect works in both directions. The fall in stock prices in Japan has contributed to a decrease in consumer spending. Recent movements in US stock market prices have caused concern among economic analysts. For example, Macroeconomic Analysts has forecasted an 8.5 percent drop in stock market prices. Decreases in stock market prices will result in decreases in consumer spending and will slow economic growth.
(Updated June 16, 1998)

Questions
  1. Draw a consumption function for the US economy.

  2. What assumption is made about net wealth when drawing the consumption function?

  3. Show on your diagram the impact of an increase in net wealth.

  4. What would be the impact on US consumption, employment and prices of a decrease in net wealth?
Source John M. Berry, "Weakened ‘Wealth Effect’ Could Slow Economy," The Washington Post, June 11, 1998.

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