Wealth elasticity of demand
Encyclopedia
Wealth elasticity of demand in microeconomics
is the proportional change in the consumption of a good relative to a change in consumers' wealth (as distinct from changes in personal income). Measuring and accounting for the variability in this elasticity
is a continuing problem in behavioral finance
and consumer theory
.
of consumption quantity for some good will determine the size of the expenditure shift due to unexpected changes in net personal wealth, ceteris paribus
(i.e. the size of the so-called "wealth effect
" for a given good). This is analogous to the definition of the income effect
from the income elasticity of demand, or the substitution effect from the price elasticity. The measure of "wealth" is mostly taken to be total personal realizable wealth at market prices, liquid or not:
Some economists say that bonds are simply a loan from the government and that they are not considered (on the aggregate) to be part of net wealth. Generally, the wealth change is measured in real
terms.
It may seem obvious that an unanticipated windfall will lead to greater consumption and that a fiscal loss will have the opposite effect. However, when the stock markets crashed in April 2000 (wiping out $2.1 trillion in nominal investor wealth) U.S. household consumption did not drop substantially.
Some researchers have tried to resolve this difficulty by redefining wealth as the 'stable underlying value' of assets, which doesn't change with asset values, although this raises other questions of consumer rationality
.
terms, so a deflation in price levels
will increase personal wealth on average (because the total wealth in society is positive, the difference between saving and debt is tangible assets, such as land). The increase in private real wealth may give wise to a wealth effect
of increased consumption. The macroeconomic effect of this on employment
is called the Pigou effect
, but whether or not this acts as a significant brake on a deflationary spiral is controversial. Pigou's reasoning for a positive wealth elasticity was that richer people feel more secure in the future and hence save less from current income. (So wealth is not redistributed by the effect.)
The elasticity has important implications for monetary policy
: Investments with a fixed yield
(such as a bond paying coupons at 5%) will increase in net present value
as interest rate
s fall. Since fixed-income bond-holders personal wealth (at market rates) has increased, this may stimulate expenditure in a wealth effect. Working the other way, central banks often need to guess the wealth elasticity for asset price changes that have already happened in order to adjust the interest rate
. In particular, the extent to which house
price rises affect the rest of the economy is a critical question.
However, this approach overlooks the fact that people [typically treat income and capital
differently. (Behavioural economics hypothesises different "mental accounts
" for income and asset
s, and points to empirical studies showing that the marginal propensity to consume
extra income is one, but is lower for windfall asset increases.)
Econometric research is ongoing to find good wealth elasticity parameter
s, especially in areas like house-price-related wealth effects. However, some patterns are widely believed to hold:
the income effect will partially cancel itself out, since people will work less as their hourly pay goes up. A change in net wealth doesn't require economic labour to produce, and has a different impact on the labour market.
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...
is the proportional change in the consumption of a good relative to a change in consumers' wealth (as distinct from changes in personal income). Measuring and accounting for the variability in this elasticity
Elasticity (economics)
In economics, elasticity is the measurement of how changing one economic variable affects others. For example:* "If I lower the price of my product, how much more will I sell?"* "If I raise the price, how much less will I sell?"...
is a continuing problem in behavioral finance
Behavioral finance
Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market...
and consumer theory
Consumer theory
Consumer choice is a theory of microeconomics that relates preferences for consumption goods and services to consumption expenditures and ultimately to consumer demand curves. The link between personal preferences, consumption, and the demand curve is one of the most closely studied relations in...
.
Definition
The wealth elasticityElasticity (economics)
In economics, elasticity is the measurement of how changing one economic variable affects others. For example:* "If I lower the price of my product, how much more will I sell?"* "If I raise the price, how much less will I sell?"...
of consumption quantity for some good will determine the size of the expenditure shift due to unexpected changes in net personal wealth, ceteris paribus
Ceteris paribus
or is a Latin phrase, literally translated as "with other things the same," or "all other things being equal or held constant." It is an example of an ablative absolute and is commonly rendered in English as "all other things being equal." A prediction, or a statement about causal or logical...
(i.e. the size of the so-called "wealth effect
Wealth effect
The wealth effect is an economic term, referring to an increase in spending that accompanies an increase in perceived wealth.-Effect on individuals:...
" for a given good). This is analogous to the definition of the income effect
Income effect
In economics, the consumer's preferences, money income and prices play an important role in solving the consumer's optimization problem...
from the income elasticity of demand, or the substitution effect from the price elasticity. The measure of "wealth" is mostly taken to be total personal realizable wealth at market prices, liquid or not:
- Wealth = cash balances + government bondsBond (finance)In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
+ housing equity + stockStockThe capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s + other assetAssetIn financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s - debtDebtA debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
Some economists say that bonds are simply a loan from the government and that they are not considered (on the aggregate) to be part of net wealth. Generally, the wealth change is measured in real
Real
Real may also refer to:* Reality, the state of things as they actually exist, rather than as they may appear or may be thought to be.-Finance:* Inflation adjusted amountsCurrencies:* Brazilian realFormer currencies:* Mexican real* Portuguese real...
terms.
It may seem obvious that an unanticipated windfall will lead to greater consumption and that a fiscal loss will have the opposite effect. However, when the stock markets crashed in April 2000 (wiping out $2.1 trillion in nominal investor wealth) U.S. household consumption did not drop substantially.
Some researchers have tried to resolve this difficulty by redefining wealth as the 'stable underlying value' of assets, which doesn't change with asset values, although this raises other questions of consumer rationality
Rationality
In philosophy, rationality is the exercise of reason. It is the manner in which people derive conclusions when considering things deliberately. It also refers to the conformity of one's beliefs with one's reasons for belief, or with one's actions with one's reasons for action...
.
Macroeconomic implications
Most researchers calculate the wealth effect in realReal
Real may also refer to:* Reality, the state of things as they actually exist, rather than as they may appear or may be thought to be.-Finance:* Inflation adjusted amountsCurrencies:* Brazilian realFormer currencies:* Mexican real* Portuguese real...
terms, so a deflation in price levels
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...
will increase personal wealth on average (because the total wealth in society is positive, the difference between saving and debt is tangible assets, such as land). The increase in private real wealth may give wise to a wealth effect
Wealth effect
The wealth effect is an economic term, referring to an increase in spending that accompanies an increase in perceived wealth.-Effect on individuals:...
of increased consumption. The macroeconomic effect of this on employment
Employment
Employment is a contract between two parties, one being the employer and the other being the employee. An employee may be defined as:- Employee :...
is called the Pigou effect
Pigou effect
The Pigou effect is an economics term that refers to the stimulation of output and employment caused by increasing consumption due to a rise in real balances of wealth, particularly during deflation....
, but whether or not this acts as a significant brake on a deflationary spiral is controversial. Pigou's reasoning for a positive wealth elasticity was that richer people feel more secure in the future and hence save less from current income. (So wealth is not redistributed by the effect.)
The elasticity has important implications for monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
: Investments with a fixed yield
Yield (finance)
In finance, the term yield describes the amount in cash that returns to the owners of a security. Normally it does not include the price variations, at the difference of the total return...
(such as a bond paying coupons at 5%) will increase in net present value
Net present value
In finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...
as interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
s fall. Since fixed-income bond-holders personal wealth (at market rates) has increased, this may stimulate expenditure in a wealth effect. Working the other way, central banks often need to guess the wealth elasticity for asset price changes that have already happened in order to adjust the interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
. In particular, the extent to which house
House
A house is a building or structure that has the ability to be occupied for dwelling by human beings or other creatures. The term house includes many kinds of different dwellings ranging from rudimentary huts of nomadic tribes to free standing individual structures...
price rises affect the rest of the economy is a critical question.
Why income and wealth elasticities are separable
A naïve assumption (or first approximation) linking the wealth and income elasticities of demand is:- Income elasticity = Wealth elasticity * rate of investment returnReturn on investmentReturn on investment is one way of considering profits in relation to capital invested. Return on assets , return on net assets , return on capital and return on invested capital are similar measures with variations on how “investment” is defined.Marketing not only influences net profits but also...
.
However, this approach overlooks the fact that people [typically treat income and capital
Financial capital
Financial capital can refer to money used by entrepreneurs and businesses to buy what they need to make their products or provide their services or to that sector of the economy based on its operation, i.e. retail, corporate, investment banking, etc....
differently. (Behavioural economics hypothesises different "mental accounts
Mental accounting
A concept first named by Richard Thaler , mental accounting attempts to describe the process whereby people code, categorize and evaluate economic outcomes....
" for income and asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s, and points to empirical studies showing that the marginal propensity to consume
Marginal propensity to consume
In economics, the marginal propensity to consume is an empirical metric that quantifies induced consumption, the concept that the increase in personal consumer spending occurs with an increase in disposable income...
extra income is one, but is lower for windfall asset increases.)
Econometric research is ongoing to find good wealth elasticity parameter
Parameter
Parameter from Ancient Greek παρά also “para” meaning “beside, subsidiary” and μέτρον also “metron” meaning “measure”, can be interpreted in mathematics, logic, linguistics, environmental science and other disciplines....
s, especially in areas like house-price-related wealth effects. However, some patterns are widely believed to hold:
- The wealth elasticity of the poor is much higher than the rich:
- If a pauper wins the lotteryLotteryA lottery is a form of gambling which involves the drawing of lots for a prize.Lottery is outlawed by some governments, while others endorse it to the extent of organizing a national or state lottery. It is common to find some degree of regulation of lottery by governments...
he'll tend to spend a large portion of the "WindfallIntertemporal consumptionEconomic theories of intertemporal consumption seek to explain people's preferences in relation to consumption and saving over the course of their life...
" within a year. - If a millionaireMillionaireA millionaire is an individual whose net worth or wealth is equal to or exceeds one million units of currency. It can also be a person who owns one million units of currency in a bank account or savings account...
wins the lottery his consumption patterns change little.
- If a pauper wins the lottery
- The size of the wealth effect is based on perceptions of the permanence of the change in wealth.
- Intertemporal consumptionIntertemporal consumptionEconomic theories of intertemporal consumption seek to explain people's preferences in relation to consumption and saving over the course of their life...
: Nominal gains in stock marketStock marketA stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...
portfolios and other assets tend to have smaller affects on immediate consumption than predicted by the lifetime-income hypothesis (of rationalRationalityIn philosophy, rationality is the exercise of reason. It is the manner in which people derive conclusions when considering things deliberately. It also refers to the conformity of one's beliefs with one's reasons for belief, or with one's actions with one's reasons for action...
consumption averaging based on NPVNet present valueIn finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...
income expectations). - Risk aversionRisk aversionRisk aversion is a concept in psychology, economics, and finance, based on the behavior of humans while exposed to uncertainty....
probably causes the wealth elasticity of consumption to drop with asset volatilityVolatility (finance)In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
. (I.e. if people think their investments can be worth much less today than tomorrow, they tend not to consume the new capital because their utilityUtilityIn economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....
curves tend to be convexConvex functionIn mathematics, a real-valued function f defined on an interval is called convex if the graph of the function lies below the line segment joining any two points of the graph. Equivalently, a function is convex if its epigraph is a convex set...
- they have a preference for averages.)
- Intertemporal consumption
Other differences from the income effect
If 'leisure time' is a superior goodSuperior good
Superior goods make up a larger proportion of consumption as income rises, and therefore are a type of normal goods in consumer theory. Such a good must possess two economic characteristics: it must be scarce, and, along with that, it must have a high price...
the income effect will partially cancel itself out, since people will work less as their hourly pay goes up. A change in net wealth doesn't require economic labour to produce, and has a different impact on the labour market.
See also
- Engel curveEngel curveAn Engel curve describes how household expenditure on a particular good orservice varies with household income. There are two varieties of Engel Curves. Budget share Engel Curves describe how the proportion of household income spent on a good varies with income. Alternatively, Engel curves can also...
- Keynesian consumption function
- Lloyd MetzlerLloyd MetzlerLloyd Appleton Metzler was an American economist best known for his contributions to international trade theory. He was born at Lost Springs, Kansas in 1913. Although most of his career was spent at the University of Chicago, he was not a member of the Chicago school, but rather a Keynesian...
added capital as a component to wealth effect in macroeconomicsMacroeconomicsMacroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy... - Wealth (economics)
- WealthWealthWealth is the abundance of valuable resources or material possessions. The word wealth is derived from the old English wela, which is from an Indo-European word stem...