wealth effect

DEFINITION: The phrase “wealth effect” refers to the change in spending habits that usually accompanies a change in an individual’s perception of his wealth.

ETYMOLOGY: The word “wealth” derives from the Middle English word welthe, which also means “wealth.” The word welthe, in turn, is connected, via the Middle English wele, to the Old English wela, meaning “weal.” Wela, in turn, is connected to the Old English wel, meaning “well.”

The word “effect” derives, via Middle English and Middle French, from the past participle, effectus, of the Latin verb efficio, efficere, meaning “to do,” “to make,” “to produce,” or “to bring about.”

USAGE: It is, of course, little more than common sense that if one feels richer, then one will spend more (and, indeed, if one feels poorer, then one will spend less).

However, the wealth effect is mainly discussed by economists in relation to the specific case in which an increase in one’s perceived wealth—and so, in spending—leads, in turn, to wider effects on the economy as a whole.

With respect to this specific case, there are several points worth making.

The first is to note that the wealth effect is, by definition, determined by a change, not in some objective measure of an individual’s wealth, but rather in an individual’s subjective perception of his own wealth.

Now, obviously, if someone gets a raise at work, he will become richer by any objective measure. Therefore, it is not surprising that he will feel richer, as well, and so is likely to spend more.

However, if property values in someone’s town or neighborhood rise, then, even though the homeowner does not have access to a larger income stream, he may feel richer by virtue of owning a more-valuable property. And this feeling may then lead him to spend more money.

This is one important aspect of the wealth effect. Here is another.

If consumer spending goes up, then that spending will act as a stimulus to the economy as a whole.

Obviously, the impact of one individual’s spending will be quite small. However, if the wealth effect is widespread enough, the cumulative impact may be considerable.

This is one of the reasons why political leaders are notorious for exaggerating how well the economy is performing. The wealth effect helps to explain this striking fact.

If people believe they are likely to get a raise or the value of their stock portfolio is likely to increase, then the wealth effect may kick in.

If it does, then those individuals might well spend more money due to such rosy prognostications. In this way, the exaggerations would become retroactively justified—a self-fulfilling prophecy.

Another aspect of the wealth effect involves the distribution of the increased spending. Namely, if a person feels wealthier and spends more money, the money is likely to be spent on different things than it would have been otherwise.

For example, money that would have been spent on fast food may be spent in a fancy restaurant, instead.

Finally, it is necessary to note that the wealth effect is somewhat controversial within the academic discipline of economics.

Some economists say the wealth effect is not empirically observable from the statistical data.

Other economists stress that the wealth effect is both psychologically intuitive and long accepted historically.

To date, there has been no widely accepted resolution to this debate, but it seems safe to say that the majority of economists believe the wealth effect exists.