Macroeconomic Advisors, a St. Louis forecasting firm, has recently estimated the relationship between gains in stock market wealth and increased consumer spending. They found that a third of last year’s 3.6 percent increase in inflation-adjusted consumer spending could be attributable to this wealth effect. From 1995 to 1997 about 30 percent of the increase in consumer spending was the result of stock market gains. Other studies have reported similar impacts in Japan, Germany, and Britain. It should be noted that increased spending reduces measured savings since stock market gains are not included as a part of current income.

The wealth effect works in both directions. The fall in stock prices in Japan has contributed to a decrease in consumer spending. Recent movements in US stock market prices have caused concern among economic analysts. For example, Macroeconomic Analysts has forecasted an 8.5 percent drop in stock market prices. Decreases in stock market prices will result in decreases in consumer spending and will slow economic growth.
(Updated June 16, 1998)

1. Draw a consumption function for the US economy.

2. What assumption is made about net wealth when drawing the consumption function?

3. Show on your diagram the impact of an increase in net wealth.

4. What would be the impact on US consumption, employment and prices of a decrease in net wealth?