FRB-Boston Paper Examines Wealth Effect

How big is the wealth effect on consumption? That’s the subject of a Boston Fed discussion paper titled, “Wealth Shocks and Macroeconomic Dynamics.” It reviews the extensive existing literature on this topic, and concludes that there are “many unanswered issues and questions.” That’s a bit unsettling since one of the Fed’s justifications for QE is that it should increase asset prices and boost consumer spending. On November 4, 2010, a day after the FOMC voted to implement QE2, Fed Chairman Ben Bernanke wrote an op-ed in The Washington Post. He noted that stock prices had already been rising in anticipation of QE2, and “higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

The paper notes that several policymakers have stated that the wealth effect is significant. There is a strong positive correlation between consumption as a share of disposable personal income and the ratio of aggregate household wealth to disposable personal income. However, econometric estimates suggest that the wealth effect is relatively small. A 2001 Fed study found that consumer spending rises by between 3 and 6 cents for every additional dollar of wealth, with the effect occurring gradually over a period of several years. The Boston paper concludes that there are lots of known unknowns about the wealth effect:

We have identified a need to learn more about the underpinnings of wealth effects and how the effects might differ for different components of household wealth, including on the liabilities side of the balance sheet. On a related topic, more work is needed to understand how aggregate wealth effects may have changed (and still are changing) over time. The research has been limited to some extent by lack of good data sources, and, accordingly, some focus should be placed on ways we can improve existing datasets and create new ones.