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Wealth Shocks and Macroeconomic Dynamics

Daniel Cooper and Karen Dynan
Karen Dynan
Karen Dynan Professor of the Practice of Economics - Harvard University, Nonresident Senior Fellow - Peterson Institute for International Economics

July 24, 2013

Abstract
The effect of wealth on consumption is an issue of longstanding interest to economists. Conventional wisdom suggests that fluctuations in household wealth have driven major swings in economic activity. This article considers so-called consumption wealth effects. There is an extensive existing literature on wealth effects that has yielded some insights. For example, research has documented the average historical relationship between aggregate household wealth and aggregate consumption, and a large number of household-level studies suggest that wealth effects are larger for households facing credit constraints. However, there are also many unresolved issues regarding the influence of household wealth on consumption. We review the most important of these issues and argue that there is a need for much more research in these areas as well as better data sources for conducting such analysis.

Introduction

The effect of wealth on consumption is an issue of longstanding interest to economists. The relationship is particularly important from a policy perspective, given the two major booms and busts in stock prices as well as the dramatic run-up and reversal of home prices experienced by the U.S. economy over the past two decades. The conventional wisdom is that the resulting fluctuations in household wealth have driven major swings in economic activity. Indeed, the plunge in wealth during the financial crisis is frequently cited as an important contributing factor to the unusually slow economic recovery from the Great Recession.

Against this backdrop, it is perhaps not surprising that a great deal of empirical research over the last 25-years has focused on so-called wealth effects—the impact of changes in wealth on household consumption and the overall macroeconomy. Such studies have used different types of data to examine the relationship between wealth and household spending, including macroeconomic time series, regional data, household survey results, and credit records. The research has yielded some important findings about the nature of wealth effects, but consensus has yet to be reached on many important issues. We review these questions and argue that there is a need for more research in the area as well as a pressing need to develop better data sources for such research.