Understanding trend and cycle in asset values: Reevaluating the wealth effect on consumption

Both textbook economics and common sense teach us that the value of household wealth should be related to consumer spending. Early academic work by Franco Modigliani (1971) suggested that a dollar increase in wealth (holding fixed labor income) leads to an increase in consumer spending of about five cents. Since then, the so-called "wealth effect" on consumption has increasingly crept into both mainstream and policy discussions of the macroeconomy.(1) Today, it is commonly presumed that significant movements in wealth will be associated with movements in consumer spending, either contemporaneously or subsequently. Quantitative estimates of roughly the magnitude reported by Modigliani are routinely cited in leading macroeconomic textbooks(2) and are important features of many contemporary macroeconomic models, including those still widely studied by both academic economists and practitioners.