The wealth effect is what happens when we are richer, or we feel richer.
And what happens when you feel (or are) richer: you spend more!
(Or that’s the theory.)
If you get paid more money, or you pocket a windfall, you may well go out and splurge a bit. And that money that you spend will juice the economy: the more stuff you buy from a store, the more money that store makes. Then the store owner goes out and buys more stuff from the manufacturer, or maybe buys another company, or maybe hires some more people, who then feel richer and go out and spend more, and so on.
So clearly there’s a wealth effect if we are richer. But what about if we just feel richer?
This happens when asset prices rise. Assets being the stuff we own, like our stock investments or our property. Say the value of your portfolio goes up, or Redfin tells you your house is worth $200,000 more than last month. You haven’t actually made any money at this point, but you are richer on paper. Which means you might feel richer. Which means you might go out for a steak dinner instead of a Chipotle burrito, or you might buy a new Mercedes, instead of a second-hand Corolla.
I say might, but this kind of thing happens all the time: the stock market goes up, or the home market booms; people look at their investments, see they’re worth more and then they go out and spend a bunch of money. That is the wealth effect in action.
It’s great for the economy, but it can be really bad for the spender. Why? Because asset prices move both ways, and the price of your shares or your home can fall just as far and as fast as it rose. And if you haven’t realized the gain, by cashing in your stocks or refinancing or selling your home, any purchases you made when you were feeling rich were made with money that you didn’t really have.
And when that sinks in, you’ll be left badly needing a drink.
Problem is, you may not be able to afford it.