Household wealth influences the decision to spend money, impacting aggregate demand. This has a significant impact on the economy, especially where household spending makes a dominant contribution to GDP.
In addition, the wealth effect may be more pronounced in countries where financial markets and financial literacy have advanced. There, households not only have alternatives to allocate investment. However, they are also more aware of how important investing is to accumulate wealth for their future.
In contrast, in underdeveloped financial markets, households may rely solely on investments such as land. Unlike stocks or bonds, such assets are illiquid and may take a long time to change in price. Thus, the impact on spending decisions is not significant.
What is household wealth?
Household wealth refers to net worth, the total value of assets owned minus all liabilities. In other words, we don’t just look at their assets when we talk about household wealth. However, we must also consider how many obligations they have.
Because wealth provides valuable clues about household consumption, it is important to consider liabilities. Take the simplified case. Say you and your friend have $1,000 in assets and $50 per month in income. However, because he financed assets from debt, your friend has a liability of $900. Meanwhile, your liability is only $100. How much income do you and your friends spend each month?
If we only look at the assets, we may conclude the wrong one. You and your friends have expenses for consumption of the same amount.
On the other hand, the conclusion will be different if we consider liabilities. Your friend may spend less money on consumption. He has to pay more obligations, which, if not paid, can swell, for example, due to high interest. Consequently, he has to set aside more income than you because he has to pay more installments.
How do households accumulate wealth?
Households save and invest their money in various assets to accumulate wealth. Their money can come from salaries, retirement income, government benefits, or other sources such as dividends and capital gains.
Where do households invest? Assets for investment generally fall into two categories:
- Financial assets include savings accounts, stocks, bonds, and mutual funds.
- Real assets such as real estate, gold, and commodities.
In developing countries, households may rely more on real assets to store their wealth. On the other hand, households in developed countries can choose both asset categories, supported by developed financial markets.
What percentage is invested varies between households. For example, some may set aside 50% of income as investment, the rest for consumption. Others may choose 70% to invest and 30% to consume.
Wealth on paper vs. realized
As the above assets increase in value, household wealth increases, assuming the liabilities do not change. However, this doesn’t mean they have more cash. As long as they have not realized the profit by selling the asset, their cash has not increased.
Say you buy a company’s stock at $10. A month later, the price was up $13. As long as you don’t sell, it’s just wealth on paper.
For example, you don’t sell it immediately to realize a profit and wait for the price to rise again. However, on the contrary, after another month, the price fell and returned to $10. As a result, your wealth had not changed compared to when you first bought it.
Regular income other than salary
Some assets enable households to earn a regular income. An example is dividends. When buying stocks, household wealth comes from rising prices and dividends received. However, unlike price increases, dividends are not wealth on paper. Instead, they receive cash (unless the company distributes stock dividends instead of cash dividends) into their accounts.
Bonds also generate regular income. Bond issuers pay coupons regularly, usually twice a year. Likewise, with property, households can get regular rental income from the property they rent out.
Long story short, household wealth is not only due to rising asset prices. But, they can increase through dividends, coupons, and rent earned. And when they reinvest that regular income, their wealth can increase much faster.
How does household wealth affect aggregate demand?
Households allocate their current income into two categories: saving and consumption. They save some of their income to accumulate wealth to meet future consumption. In other words, we can say, saving represents delayed future consumption.
Wealth accumulation target
Households create wealth accumulation plans for their savings. It helps them increase their net worth. They map out which assets they invest in and their expected return targets.
As the market value of their assets increases, so does their wealth. Increased wealth makes them more confident and feels richer. They can reach the target faster. Thus, they are willing to save less on their additional income because they can still meet their wealth accumulation goals.
For example, say you target your wealth to be $125 at the end of December by setting aside 50% of your income (say $10) every month. You find your assets continue to increase. In November, you see your wealth has reached the target of $125. You’re happy with it and may decide not to save your $10 income in November because you’ve hit your target. Instead, you use $10 for consumption, for example, to buy the item you are interested in.
Effect on aggregate demand
The case above is a simplified example of how households change their decisions about saving and consumption considering their wealth. When assets increase in value, households feel wealthier. They are then willing to spend more of their income on current consumption without compromising their target wealth. As a result, increased household consumption ultimately increases aggregate demand in the economy.
Stronger demand encourages businesses to increase production. As a result, they invest in capital goods and recruit more workers. As a result, aggregate demand strengthened further, and the unemployment rate declined. This situation improves income and employment prospects for households, prompting them to increase spending.
On the other hand, strong demand increases business profits, pushing their share prices. Ultimately, it makes households richer as the stock they hold increases in value.
However, when asset prices fall, they may have the opposite effect. Households find it difficult to achieve wealth accumulation targets. Thus, they may reduce consumption. In contrast, they allocate more income to savings. Long story short, their decline in wealth reduces spending on goods and services, weakening aggregate demand.
Due to weak demand, businesses began to delay investment. Instead, they take efficiency measures, including perhaps reducing the workforce. This situation ultimately led the economy to weaker growth.
Economists refer to the relationship between wealth and household consumption as the wealth effect. They use it, for example, to explain the relationship between the stock market and real estate and other macroeconomic variables such as real GDP.
Why is it difficult to measure how significantly household wealth affects aggregate demand?
How significantly wealth affects the economy can be difficult to estimate. That’s because the increase in asset value also occurs due to changes in economic conditions. For example, stocks will rise during expansion because the business faces better profitability prospects. On the other hand, during a recession, stock prices fall as business profitability falls due to a deteriorating demand outlook.
So, which one is correct: Do changes in wealth affect economic growth, or conversely, does economic growth affect household wealth? Let’s say the two factors influence each other. Economic growth affects household wealth and ultimately strengthens growth through the wealth effect. Finally, another difficulty arose. We must isolate past wealth changes from economic growth changes to estimate the wealth effect’s significance.
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