The Wealth Effect Definition
The wealth effect refers to a theory stating that the increase in the worth of equity portfolios as a result of increasing stock prices in the market, can instill a sense of confidence in the investors about their wealth, and ultimately, increase their expenditure. For example, the 10% increase in tax rate, enforced in the year 1968, was unable to control consumer expenditure. Gradually, the sustained expenditure made by consumers was added to the wealth effect. In spite of the decrease in disposable income of a consumer due to excessive tax rate, there was no effect on the wealth, and instead, it continued to rise with the rising stock market.
A Little More on What is the Wealth Effect
The wealth effect can have a positive impact on the economic growth of a country at the time of bull stock markets. If investors recognize a significant rise in investment securities, they feel confident about their wealth’s sustainability, and their expenditure levels. However, poor equity performance in bear markets hurts investors’ confidence and economic growth.
The wealth effect creates the psychological effect that the increase in asset values has a direct impact on consumer spending. This states that the consumer confidence automatically improves when the value of assets rises. And this confidence results in more spending, and less savings by customers. This approach will take place no matter if the income rises or falls.
Rising Portfolio Value and Disposable Income
If there is an increase in the portfolio of an investor, it doesn’t mean that its disposable income will be more as well. In the initial stage, gains derived from stocks should not be considered as ‘realized’ since they are still associated with investments. An unrealized gain refers to a profit that is present on a piece of paper alone, and has still to be sold in exchange for cash.
Validity of the Wealth Effect Theory
Market experts are still trying to find the authenticity of the wealth effect in the stock market. There are experts who are of the view that this effect is more related with correlation rather than causation, stating that increase in spending levels results in asset appreciation.
There are solid evidences proving that increased expenditure results in increasing the value of property. Supporters of the wealth effect say that if interest rates are less and credit is more easily availed, the consumers will be tempted to buy more. This proves to be true for the housing sector. If interest rates are less, there will be more sales of homes. And as demand exceeds supply in this case, this will ultimately increase the worth of homes.