Tuesday, June 10, 2008

Inverse Wealth Effect

There's been a lot of press about the "wealth effect". Supposedly, if people feel wealthier, such as when house prices rise, they spend more. More recently, we've heard a lot about the inverse wealth effect. As people feel poorer, such as when house prices fall, they spend less. This is certainly true to some degree, but what is the real impact?

Yet the idea of a wealth effect doesn't stand up to economic data. The stock market boom in the late 1990s helped increase the wealth of Americans, but it didn't produce a significant change in consumption, according to David Backus, a professor of economics and finance at New York University. Before the stock market reversed itself, "you didn't see a big increase in consumption," says Backus. "And when it did reverse itself, you didn't see a big decrease."

Just another example of a popular notion that turns out to be wrong. Beware of simple explanations for complex topics.

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