Welcome to professrsavings.com, we teach finance basics.
Today we will teach you the term wealth effect in two minutes.
You should care because you might realize that spending habits may be related to psychology.
The wealth effect is the idea that people to spend more as the value of their assets rises.
This makes sense. Duh!!! Make more, spend more. When broke, do less.
Let’s say your home or investment portfolios increase in value, you’ll feeling like things are going well. So you deserve to spend more.
Buy new clothes. Pimp up your ride.
But when consumers see the value of their homes or portfolios fall, they are more cautious. Some even panic a bit.
The wealth effect attempts to explain why consumers might change their spending habits even if their income and fixed costs have stayed the same.
Here is an example of how the wealth effect works.
Professor Savings purchased a house for $500,000 in 2010. She earned a $120,000 salary and his average expenses, including housing, were $85,000 per year.
In 2012, the global economic crises lowered his home’s value to $350,000
Professor Savings income was still $120,000 and his expenses were still $85,000 but she cut back on his variable expenses because she was concerned about the drop in his home equity.
So Professor Savings tarted spending $50,000 a year instead of $85,000
In 2014 when his home’s value rebounded and grew to $600,000 Professor Savings felt more secure as his home equity increased and started spending more again.