A Behavioral Life-Cycle Approach to Understanding the Wealth Effect
Originally published in Business Economics, 43(2) April 2008.
The somewhat surprising strength in consumer spending in recent years has focused renewed attention on the much-debated wealth effect, the notion that when individuals feel wealthier, they consume more. This study utilizes survey data to examine the wealth effect within the context of the behavioral life-cycle model of savings. The results indicate that the likelihood of households spending more when their assets increase in value decreases with the portion of assets held in home equity. This unexpected finding is due to homeowners responding to the perceived wealth gain from increased home values by cashing out their equity. The likelihood increases with the portion of assets held in stock outside of retirement accounts, but is not significantly related to the portion of assets held in stock overall. Moreover, households that have a full-time income earner, are homeowners, have more education, have a younger household head, or expect economic growth, are more likely to report a wealth effect. Households that utilize savings “rules of thumb” are less likely to report a wealth effect. These results can be used to improve the wealth effect specification in consumer demand models and assist firms to target consumer markets.