The wealth effect The wealth effect refers to the propensity of people to spend more if they have more assets. The premise is that when the value of stocks increases, our wealth and disposable income also increase, so we feel more comfortable spending. The wealth effect helped fuel the U.S. economy in 1999 and part of 2000, but what happens to the economy if the market tanks? The Federal Reserve reported that for every $1 billion in stock value increases, Americans will spend an additional $40 million per year. The wealth effect has become a growing concern as more and more people invest; furthermore, the Federal Reserve has very little direct control over stock prices. The numbers are staggering. Since the end of 1995, household stocks have doubled to more than $12 trillion. And, for the first time, stocks are the most valuable asset of the typical American family, not the house. When it comes to spending money, consumers take into account all of their financial assets, from income to housing. When an asset rises in value for an extended period of time, like the stock market in the 1990s, people feel good and are willing to spend a little more money, perhaps buying a luxury car or taking a more expensive vacation . A good number of Wall Street analysts attribute the cause of today's negative savings rate to the wealth effect. Falling stock prices affect companies in several ways. First, falling stock prices, driven primarily by profit warnings, increase shareholder pressure on managers to cut costs by laying off workers and scaling back investment. Second, the recent correction has put many stock options underwater, and it's unclear to what extent workers will bargain for more cash in lieu of options and how that might affect payroll costs and inflation. Third, factors that drag down stock prices typically push investors to demand higher risk premiums, which increases the cost of financing corporate investments. This takes the form of widening corporate bond and commercial paper interest rate spreads over Treasury yields and lower prices for any new stock a company dares to offer. In addition to increasing the current price of new financing, the increased uncertainty associated with declining stock prices can scare investors so much that they reduce the availability of financing. From... middle of paper... bear market if we remain at war for an extended period in the future. We have seen steady gains in the major stock indexes over the past month. Some argue that the bull market could return with the war on terrorism going well, while others insist that the gains are only short-term and that the market will retest the lows hit in mid-September. Only time will tell how long it will take for our market to fully rebound into a bull market like we saw in the 1990s. Sources 1.) Balke, Nathan. “The economy in action”. Federal Reserve Bank of Dallas.2.) Angeletos, George, David Laibson, Andrea Repetto, Jeremy Tobacman, and Stephen Weinberg. The hyperbolic buffer stock model. March 3, 2001.3.) Clarke, Grahm, and Steven Caldwell. “Wealth in America.” Ohio State 1998.4.) Fidelity Investments. Estimated effects of stock wealth on consumption in 2001. 5.) American Express Company. 2001 American Express “Everyday Spending” Survey. 6.) John Khoury. Yahoo Finance: 2001.