What Is the Wealth Effect, and How Does It Affect You?

What Is the Wealth Effect?

The wealth effect is a theory that suggests that households spend more money due to a rise in the value of their assets, like homes and stock portfolios. As the value of these assets increases, consumers feel more financially secure. Therefore, they’re willing to buy more things, even if income and fixed expenses remain the same. 

Research from economics professors Christopher Carroll and Xia Zhou estimates the strength of the wealth effect. Their studies show homeowners increase annual spending by six cents for every extra dollar of home equity. 

A 2019 study from the National Bureau of Economic Research found that increased stock market value similarly increases consumer spending, with consumers spending 2.8 cents more per year for every dollar of increased stock market wealth. 

While some economists believe the wealth effect can stimulate the economy, there is limited evidence that consumers benefit from economic growth caused by increased consumer spending. However, consumers can suffer long-term financial consequences if the increase in spending causes a decrease in savings. 

Keep reading to learn how wealth effect economics can impact both you and the economy as a whole. 

What Causes the Wealth Effect? 

The wealth effect can be explained by behavioral economics, which studies how human psychology influences consumers’ economic decisions. The wealth effect reflects the way humans respond to feelings of security.

In “The Psychology of Security,” security expert Bill Schneier writes, “The feeling and reality of security are certainly related to each other, but they’re just as certainly not the same as each other.”

When consumers feel their wealth is growing because of the increasing value of their homes and stock portfolios, they feel more secure. If consumers feel secure, they are more likely to neglect the habits that protect them from financial risks, like building their savings and living frugally.

When Has the Wealth Effect Been Observed?

A 2015 Federal Reserve Bank of Boston study found evidence of the wealth effect during the early 2000s when personal wealth rose due to quickly rising home values. The study states, “We find strong positive effects on consumption growth in the subprime boom and strong negative effects during the Great Recession.”

The following data from Trading Economics shows consumer spending rising throughout the first decade of the 2000s as housing wealth increased rapidly. Following the 2008 housing market collapse, consumer spending dropped as homeowners lost significant amounts of equity in their homes. 

In 1990, the wealth effect was also observed when the U.S. entered an eight-month recession triggered by rising interest rates and a monetary policy enacted by the Federal Reserve. This recession included a 26% decline in the stock market, while home prices dropped 0.9%. 

Although a 0.9% drop may seem small, other than during the Great Recession, the 1990 recession is the only recession in recorded history that caused a decrease in home values.

Debate Surrounding the Wealth Effect

The wealth effect can be challenging to measure because economic events rarely happen in isolation. For example, as the stock market and homes rise in value, job openings may increase, making workers feel more secure that if they experienced a job loss, they could easily find work again. Because of the challenge in measuring the wealth effect, some experts question its validity. 

David Backus is one prominent economist who doubts the accuracy of wealth effect economics. He cites consumer spending habits during the stock market boom in the 1990s as evidence that the wealth effect is not a guarantee. Speaking with Slate in 2008 about the 90s, Backus said, “You didn’t see a big increase in consumption. When it did reverse itself, you didn’t see a big decrease.”

The wealth effect is similarly difficult to observe in 2022. Throughout 2021, homeowners saw their home equity and stock portfolios grow quickly. In 2022, however, the stock market quickly reversed, causing trouble on Wall Street. The S&P 500 reached a 20% decline in September. Despite this decline, Jason English, lead equity analyst at Goldman Sachs, says consumer spending is still strong in 2022. 

“Expenditures on durable goods fell 5.5% in the second quarter of 2022 accounting for inflation, while real personal consumption expenditure for services rose 4.6%, driving overall PCE up 1.8% compared to the year before,” English writes in “Consumers Are a Bright Spot for an Economy in Turmoil.”

A National Bureau of Economics Research paper offers an explanation for why consumer spending didn’t seem greatly affected by stock market declines in 2022 and the very early 2000s. The paper states, “Consistent with several recent studies, we find a housing wealth effect that is substantially larger than the stock wealth effect.”

How Does the Wealth Effect Impact You?

Because consumer spending is nearly 70% of the U.S. GDP, GDP increases when consumers feel financially secure enough to spend more money. Many people believe a growing GDP means the stock market and home values will continue to grow, adding to consumers’ personal wealth. Unfortunately, this isn’t necessarily true. 

Vice President of MSCI Research Navneet Kumar refers to the period of 1990–2020 when he says, “During this period, GDP growth was not a strong indicator of stock-market returns.”

Because increased consumer spending doesn’t always translate to better investment returns and increased consumer wealth, the wealth effect can be dangerous for your finances. When income doesn’t increase, but spending does, most people stop or slow their rate of saving. The following chart shows how the wealth effect causes a decline in personal savings as the stock market rises.

Decreasing your savings rate can be a huge hit to your long-term financial well-being. For example, if a 35-year-old saving $9,000 per year decides to take a year of contributing to their retirement savings, at the age of 67, they’ll have nearly $160,000 less than they would have if they had continued to save. 

Economist David L. Thornton writes for the St. Louis Federal Reserve about how a high savings rate can benefit the economy as a whole. He says, “A higher saving rate in the current quarter is associated with faster (not slower) economic growth in the current and next few quarters.” 

Keep Saving as Your Wealth Grows

Because saving money is important for personal financial security and the economy’s health, consumers should be aware of the wealth effect and be careful to avoid overspending.

Gerstein Fisher Founder Gregg Fisher says, “If there comes a time in your life where you’re feeling wealthy—your income feels safe, your assets are growing, your home is growing, those are the times to keep saving aggressively.”

To avoid getting caught in a trap of overspending, set high saving and investing goals. Don’t compromise on those goals as your feelings of financial security fluctuate throughout good economic times and bad. 

To learn more about personal finance, wealth, and investing, check out:

Wealth Hurts Your Capacity For Empathy (Here’s What To Do About It) 

10 Budgeting Tips to Increase Your Money Management Skills

Buying a Fixer-Upper? Here’s What You Should Know First