Thanks to Ben Bernanke, the Federal Reserve Chairman, we now have "wealth effect", which would apparently help in reducing the alarming unemployment rate, and help the common man fight inflation. Ben Bernanke is good at what he does, and I hope that his hypothesis on the impact of "wealth effect" in the growth of the economy becomes a reality.
The Wealth Effect
What is the wealth effect? Well, in simple words, wealth effect can be stated as the increase in the money that a person spends, when he believes that his wealth has increased. The perception of the increase in wealth may arise when the value of his assets go up. The assets may include, property, stocks, gold, etc. When the value of the assets increase, a person feels 'rich', and due to this, he tends to splurge rather than save. An important aspect that you should take into consideration is that, here the actual wealth of a person has not increased, but the value of money has decreased!
Inflation can be termed as the rise in the price of commodities. Majority of the population is facing the problem of inflation. The price of almost every commodity has increased substantially in the recent years. Generally, inflation is termed as progressive, which implies that, the probability of reducing the rate of inflation is very less. It might sound like an exaggeration, but every major government policy is affected by the inflation, and the policy makers are trying very hard to formulate a way to tackle the increase in prices, and to keep the rate of inflation stable.
To understand the relationship between inflation and the wealth effect, it is important to understand the relation that exists between inflation and the aggregate expenditure. The total expenditures usually tend to decrease with the increase in the prices, whereas a fall in prices will increase the aggregate expenditures. This clearly indicates that, in case of inflation, the average expenditure will decrease, but statistics suggest that there has been an increase in the total expenditures, even in the times of inflation. This increase can be credited to the wealth effect. The rise in the value of the assets, creates an apparent increase in the wealth, which motivates the 'rich' to spend more, even though there is no significant growth in their income. Thus, if the rate of inflation is 2%, and the rise in the value of the assets of a person is 5%, the owner of the assets will eventually feel that he has made a profit, and will indulge in spending, feeling that he does not have to save now, as his wealth has increased. Moreover, if the value of the assets of a person does not rise with inflation, he begins to feel that he has become poor, and thus he would control his spending, and there will be shortage in the demand, and this in turn, will reduce the aggregate expenditures.
Manipulate Wealth Effect
The Fed has proposed loose monetary policies, which will favor the increase in the value of stocks, this will lead to the wealth effect, which will encourage the businessmen to spend on labor, thereby creating job opportunities. The employment, in turn, will help people to generate income and eventually spend on commodities. The rise in the consumption of commodities, will ultimately benefit stock values, thus forming a cycle. This will help in mobilizing the economy and assist in its growth.
The wealth effect can be used as a means to cover up the damages of inflation, but the bubble will burst sooner or later, and the effects of inflation will be out in the open. So, the next time the value of your assets rise, make sure whether your wealth has actually increased, or are you being subjected to the wealth effect!