Wealth effect

The wealth effect is the change in spending that accompanies a change in perceived wealth. Usually the wealth effect is positive: spending changes in the same direction as perceived wealth.

Changes in a consumer's wealth cause changes in the amounts and distribution of his or her consumption. People typically spend more overall when one of two things is true: when people actually are richer, objectively, or when people perceive themselves to be richer—for example, the assessed value of their home increases, or a they own goes up in price.

Demand for some goods (called inferior goods) decreases with increasing wealth. For example, consider consumption of cheap fast food versus steak. As someone becomes wealthier, their demand for cheap fast food is likely to decrease, and their demand for more expensive steak may increase.

Consumption may be tied to relative wealth. Particularly when supply is highly inelastic—or in the case of monopoly—one's ability to purchase a good may be highly related to one's relative wealth in the economy. Consider for example the cost of real estate in a city with high average wealth (for example New York or London), in comparison to a city with a low average wealth. Supply is fairly inelastic, so if a helicopter drop (or gold rush) were to suddenly create large amounts of wealth in the low wealth city, those who did not receive this new wealth would rapidly find themselves crowded out of such markets, and materially worse off in terms of their ability to consume/purchase real estate (despite having participated in a weak Pareto improvement). In such situations, one cannot dismiss the relative effect of wealth on demand and supply, and cannot assume that these are static (see also General equilibrium).

However, according to David Backus the wealth effect is not observable in economic data, at least in regards to increases or decreases in home or stock equity. For example, while the in the late 1990s (q.v. dot-com bubble) increased the wealth of Americans, it did not produce a significant change in consumption, and after the crash, consumption did not decrease.

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