Thursday, August 27, 2009

Role of Wealth in the Determination of Aggregate Consumption

Wealth is an important factor which affects the consumption is wealth. As we know that the wealth of any entity, such as household or an entire nation, equals its assets minus its liabilities.

To see how consumption and saving respond to an increase in wealth, suppose that while cleaning out her attic Prudence finds a stock certificate for so shares of stock in a pharmaceutical company. Prudence’s grand mother bought this stock for Prudence when she was born, and Prudence did not know about it. She immediately calls her broker and learns that the stock is now worth $3000. This unexpected $3000 increase in Prudence’s wealth has the same effect on her available resources as the $3000 increase in current income that he has. As in case involving an increase in her current income Prudence will use her current income. Prudence will use her increase in wealth to increase her current consumption by an amount smaller than $3000 so that she can use some of the additional $3000 to increase her future consumption. Because Prudence’s current income is not affected by finding the stock certificate, the increase in her current consumption is matched by a decrease in current saving of the same size. In this way an increase in wealth increases current consumption and reduces current saving. The same line of reasoning leads to conclusion that a decrease in wealth replaces current consumption and increase saving.

The ups and downs in the stock market are an important source of changes in wealth and the effects on consumption of change in the stock market are explored in the following Application.

On October 19, 1987 stock prices took their biggest one-day plunge. The standard and Poor’s index of 500 stocks dropped 20% that day, after having fallen by 16% from the market’s peak in August of he same year. Although estimates differ, apparently $1 trillion of financial wealth (equal in value to nearly three nonths of GDP) was eliminated by decline in stock prices on that single day.

According to economic theory, how should a stock market crash affect consumer’s spendings? There are two possible channels. First, the crash reduced household’s wealth, which should have reduced consumption. According to economic theory, however the decline in consumption should have been much smaller than the $1 trillion decline in wealth, because consumer would spread the effects of their loses over a long period of time by reducing planned future consumption as well as current consumption. We can get a quick estimate of the effect of $1 trillion drop in stock values on current consumption by supposing that consumers spread their reduction in consumption over twenty five years. Also for simplicity we assume that the real interest rate is zero. Hence in response to $1 trillion loss in wealth consumers would plan to reduce their consumption in each of the next twenty five years by 1/25 of $1 trillion or $40 billion per year.

Second, a crash could affect consumption by leading consumer’s to expect bad economic times and declining income in future. As discussed above a reduction in expected future income tends to reduce current consumption and increasing current savings. Surveys of consumer’s attitudes found significant declines in consumer confidence about the future in the months following the crash.

We have seen that a precipitous decline in the stock market can cause consumption to fall below the level it would have attained otherwise. But does the relationship between the stock market and consumption hold when the stock market rises sharply? The US experienced a consumption boom in 1990’s with consumption increasing from 66.1% GDP in 1989 to 69.3% GDP in the second quarter of 1999.

Was this consumption boom caused by the stock market boom in 1990’s? Our theory predicts that a large increase in wealth, such as the one that resulted from the boom in stock prices should increase consumption.

Jo na than Parker of the University of Wisconsin who examined the behaviour of consumption and savings in US during 1980’s and 1990’s pointed out that the consumption boom began before the 1990’s boom in the stock market. The ratio of consumption to GDP increased from 62.3% in 1979 to 66.1% in 1989, an ever larger increase than that seen during the 1990’s. Real stock prices doubled during the 1980’s but this increase was substantially smaller than the tripling of real stock prices in the 1990’s. Parker concluded that no more than one fifth of the increase in ratio of consumption to GDP during that period resulted from the increased wealth associated with the stock market boom. Thus, while Parker found some evidences consistent with our theory’s prediction that an increase in wealth will cause an increase in consumption.

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