The Wealth Effect

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The Wealth Effect The "Wealth Effect" refers to the propensity of people to spend more if they have more assets. The premise is that when the value of equities rises so does our wealth and disposable income, thus we feel more comfortable about spending. The wealth effect has helped power the US economy over 1999 and part of 2000, but what happens to the economy if the market tanks? The Federal Reserve has reported that for every $1 billion in increase in the value of equities, Americans will spend an additional $40 million a year. The wealth effect has become a growing concern because more and more people are investing; furthermore the Federal Reserve has very little direct control over stock prices. The numbers are staggering. Since the end of 1995, household stock holdings have doubled to more than $12 trillion dollars. And, for the first time, equities are the most valuable asset of the typical American household, not the home. When it comes to spending money, consumers take all their financial resources into consideration, from their income to their home. When an asset surges in value for a sustained period of time, such as the stock market in the 1990s, people feel flush and are willing to spend some additional money, perhaps by buying a fancy car or by taking a more expensive vacation. A good number of Wall Street analysts blame the wealth effect for today's negative savings rate. Declining stock prices affect firms in several ways. First, lower stock prices, especially induced by profit warnings, increase shareholder pressure on managers to cut costs by laying off workers and scaling back investment. Second, the recent correction has put many stock options underwater, and it is unclear to what extent workers will bargain for more cash in place of options and how this might affect payroll costs and inflation. Third, the factors dragging down stock prices typically spur investors to demand higher risk premiums, which boosts the cost of financing business investment. This takes the form of increased spreads of corporate bond and commercial paper interest rates relative to Treasury yields and lower prices for any new stock that any firm dares to offer. Aside from raising the going price of new finance, the increased uncertainty associated with lower stock prices can spook investors so much, that the availability of finance is reduced. Since the... ... middle of paper ... ...bear market if we remain at war for a long time in the future. We have seen in the past month, steady gains in the major stock indices. Some are stating that the bull market may be back with the war on terrorism going well, and others are insisting that the gains are only short term and that the market will retest the lows hit in mid-September. Only time will tell on how long it will take for our market to completely rebound into a bull market like we saw in the 90’s. Sources 1.) Balke, Nathan. “The Economy in Action”. Federal Reserve Bank of Dallas. 2.) Angeletos, George , David Laibson, Andrea Repetto, Jeremy Tobacman, and Stephen Weinberg. The Hyperbolic Buffer Stock Model. 3 March 2001. 3.) Clarke, Grahm and Steven Caldwell. “Wealth in America”. Ohio State 1998. 4.) Fidelity Investments. 2001 Estimated Stock Wealth Effects on Consumption. 5.) American Express Company. 2001 American Express “ever day spending” survey. 6.) John Khoury. Yahoo Finance: http://finance.yahoo.com. 7.) U.S. Census Bureau. www.census.gov/. 2001. 8.) Swanson, KC. Is the “negative wealth” effect all its cracked up to be. The Street.com 29 March 2001.
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