The Pauper Effect
Topic Aggregate Demand/Aggregate Supply
Key Words Recession, Soft Landing, Interest Rates, Wealth Effect
News Story

When Alan Greenspan, chairman of the Federal Reserve, began raising interest rates 18 months ago, one of his primary objectives was to moderate wealth effect spending that resulted from soaring stock markets. The Nasdaq index is down 36% this year and 48% from its high in the spring of last year, while the Dow Jones index is off 7% this year. These declines have erased about $2 trillion in stock value and virtually eliminated wealth effect spending. The ensuing decline in consumer spending will likely cause the Fed to abandon its view that the greatest threat to the economy is inflation.

Greenspan, in a speech he gave on December 5, said that the wealth effect had been "significantly attenuated." How significant an impact will this have on the economy? Interviews with consumers across the country suggest spending by consumers -- attributable to increased portfolio values -- has ended. Consumer spending, adjusted for inflation, rose only 3.1 percent in the spring, and 4.5 percent this summer, after rising 8 percent last winter. The magnitude of the wealth effect is not known precisely. One study estimates the wealth effect at 3 cents per dollar. This translates into only a 30 percent reduction in the growth of consumer spending if the wealth effect were to end. In other words, as employment and income appear to be the primary determinants of consumer spending, low unemployment and growing wages should be enough to keep us out of a recession.

Not everyone believes that the wealth effect is dead. Home prices are high and increasing in some areas of the country. Even with the recent plunge in stock values, investors still have substantial capital gains that could fuel spending. Consumer spending will decline, the economy will slow and although the decreased growth might feel like a recession, it won't be.

(Updated January 1, 2001)

1. What is the wealth effect? Describe how it affects aggregate demand.
2. What happens to aggregate demand when there is a significant decrease in individual wealth. Illustrate using an aggregate demand/aggregate supply diagram, the impact of reduced wealth on equilibrium GDP and the price level.
3. Suppose that unemployment increases. What impact will this have on aggregate demand and the economy? Illustrate this impact on your diagram.
Source George Hager and Dina Temple-Raston, "Falling stocks smash nest eggs," USA Today, December 19, 2000.

Return to the Aggregate Demand/Aggregate Supply Index

©1998-2002  South-Western.  All Rights Reserved   webmaster  |   DISCLAIMER