Wealth elasticity of demand
1883907
148670367
2007-08-02T07:16:39Z
Hongooi
578993
/* Why the income and wealth elasticities are separable */
'''Wealth elasticity of demand''' in [[microeconomics]] is the relation of the [[Proportionality (mathematics)|proportional]] change in consumption of a [[good (economics)|good]] to a proportional change in [[Wealth (economics)|wealth]] (as distinct from changes in personal [[income#Meaning in economics and use in economic theory|income]]). Measuring and accounting for the variability in this [[Elasticity (economics)|elasticity]] is a continuing problem in [[Behavioral finance]] and [[Consumer theory]].
==Definition==
The wealth [[Elasticity (economics)|elasticity]] of consumption quantity for some good will determine the size of the expenditure shift due to ''unexpected'' changes in net personal wealth, [[ceteris paribus]]. 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:
:Wealth = Cash balances + [[Treasury]] [[Bond (finance)|Bonds]] + [[Real Estate]] equity + [[Stock]]s + Other [[asset]]s - [[Debt]]
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 [[rational]]ity.
==Macroeconomic Implications==
Most researchers calculate the wealth effect in [[real]] terms, so a [[deflation]] in [[consumer price index|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.
==Why the 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 * [[return on investment|rate of investment return]].
However, this approach overlooks the fact that people [[Consumer behaviour|typically treat]] income and [[capital]] differently. ([[Behavioural economics]] hypothesises different "[[Mental accounting|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 [[real estate|house]] [[pricing|price]] 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 [[lottery]] he'll tend to spend a large portion of the "[[Intertemporal consumption|Windfall]]" within a year.
** If a [[millionaire]] wins the lottery his consumption patterns change little.
* The size of the wealth effect is based on perceptions of the ''permanence'' of the change in wealth.
** [[Intertemporal consumption]]: Nominal gains in [[stock market]] portfolios and other [[assets]] tend to have smaller affects on immediate consumption than predicted by the [[lifetime-income hypothesis]] (of [[rational]] consumption averaging based on [[Net present value|NPV]] income expectations).
** [[Risk aversion]] probably causes the wealth elasticity of consumption to drop with asset [[volatility]]. (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 [[utility]] curves tend to be [[convex function|convex]] - they have a preference for averages.)
===Other differences from the Income effect===
* If 'leisure time' is a [[superior goods|superior good]] 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 (economics)|labour]] to produce, and has a different impact on the [[labour market]].
==See also==
* [[Engel curve]]
* [[Keynesian]] consumption function
* [[Lloyd Metzler]] added capital as a component to wealth effect in [[macroeconomics]]
* [[Wealth (economics)]]
* [[Wealth]]
==External links==
* [http://www.econweb.com/texts/current/Mansions/mansions.html Wealth elasticity of demand for mansions > 1]
[[Category:Economics effects]]
[[Category:Intertemporal economics]]