What is wealth effect? It’s the appreciation in value of assets

What is wealth effect? It’s the appreciation in value of assets
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First Published: Sun, Sep 27 2009. 09 25 PM IST

Updated: Sun, Sep 27 2009. 09 25 PM IST
Economics may not have been your grandma’s favourite subject but this is one subject which has lots of scope for storytelling. We tell you one such story.
There was a country where many believed that you could become rich simply by owning an asset. It could be a home or even the stock of a firm, the value of which would simply keep on appreciating, thanks to your markets. Economists had a great time explaining what is called the wealth effect.
Things worked like that for a while but one day the same markets tilted the balance of power in favour of those who actually tilled the fields or ran factories. Now the same economists are trying to figure out the consequences of the so-called “wealth effect” going down the drain.
Johnny: The story seems familiar, Jinny. But it would make a lot of sense if you could also explain what wealth effect is.
Jinny: Wealth effect is something which comes along with the appreciation in value of your assets such as a home or a stock. You must keep in mind that every asset does not appreciate in value. For instance, the value of the car you own is depreciating every day and one day it might sell at the price of scrap.
Of course, things could turn out differently if you preserve it as an antique piece. Things stand on a different footing for stocks and bonds or real estate. Their prices are determined by a market that could very well push them up or down. When the value of a house or a stock is appreciating, their owners feel richer and the same feeling creates the wealth effect.
Many economists feel that the increase in wealth effect leads to higher consumption. The feeling of getting rich encourages people to spend more, whereas a decrease in wealth effect leads to lower spending.
Johnny: The feeling of getting rich seems to have its own side effects. Has anybody tried to gauge the extent to which the wealth effect influences consumption?
Illustration: Jayachandran / Mint
Jinny: Well, there has been no dearth of studies, although each study arrives at its own conclusion. The most conservative estimates completely refute the presence of any wealth effect. These economists believe that increase or decrease in prices of assets has no effect on total consumption because the change in prices only transfers wealth from one person to another. If the present owner is getting rich with rising home prices, the prospective homeowner is getting so much poorer.
In a nutshell, nothing new is being added to or subtracted from the economy.
But there are economists who believe that there is indeed something called wealth effect which can push consumption upwards or downwards. However, their estimates also vary. Franco Modigliani, a Nobel Prize-winning economist, who developed a life cycle theory of household savings and consumption during the 1950s, estimated that for every one dollar increase in wealth, people increased their consumption by 5 cents. Five cents hardly look like a mountain of money but when your wealth is worth trillions of dollars, the likely wealth effect would be in billions, something which we can never ignore. But many other economists believed that what Modigliani estimated could not be accepted as a universal truth. Some studies reach a more humble estimate. For instance, some studies point out that the actual increase in consumption is in the range of 2-3 cents in the US. Estimates, no doubt, would vary for different countries, because different societies have different attitudes towards new found wealth. This is one area which still needs to be thoroughly explored by the economists of different countries.
Johnny: New explorations will continue. But can you tell me why wealth effect influences consumption?
Jinny: There are many explanations for that, too. The increase in the value of assets or the so-called feeling of wealth makes people believe that they need to save less for the future. Lower savings, it is believed, leads to higher consumption. Modigliani proposed that consumption is influenced by two factors—expectations about people’s future income and their current wealth. While making any decision, people take into account their entire life cycle.
So longer-lasting wealth has a longer-lasting wealth effect. The wealth effect created by real estate would have a greater impact as the prices of real estate rise or fall after a long gap, thereby creating a longer-lasting wealth effect.
But the wealth effect created by rising stock markets would be fleeting in nature due to frequent changes in prices.
Studies also point to the fact that the increase in price of real estate increases its value as collateral for obtaining loans from financial institutions. So rising home values could very well work like a money machine.
The possibilities seem to be endless and there are many things about the wealth effect that we do not know yet.
Johnny: That’s true, Jinny. What we don’t know about the wealth effect could be more interesting than what we already know.
What: “Wealth effect” is created by the appreciation in value of assets such as homes or stocks.
How: The increase in wealth makes people believe that they need to save less for the future. This leads to higher consumption.
How much: Franco Modigliani estimated that every one dollar increase in wealth increased consumption by 5 cents.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Sun, Sep 27 2009. 09 25 PM IST