The wealth 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. It is calculated as the ratio of the percent change in consumption to the percent change in wealth that caused it. 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: Some economists say that bonds are simply a loan to the government and that they are not considered 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 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 rationality.
Macroeconomic implications
Most researchers calculate the wealth effect in real terms, so a deflation in price levels will increase personal wealth on average. The increase in private real wealth may give rise 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. The elasticity has important implications for monetary policy: Investments with a fixed yield will increase in net present value as interest rates fall. Since fixed-income bond-holders’ personal wealth 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 increases affect the rest of the economy is a critical question.
Why income and wealth elasticities are separable
A naïve assumption linking the wealth and income elasticities of demand is:
However, this approach overlooks the fact that people typically treat income and capital differently. Econometric research is ongoing to find good wealth elasticity parameters, especially in areas like house-price-related 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 "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 effects on immediate consumption than predicted by the lifetime-income hypothesis.
* Risk aversion probably causes the wealth elasticity of consumption to drop with asset volatility.
Other differences from the income effect
If 'leisure time' is a 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 to produce, and has a different impact on the labour market.
