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 ext ...