Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Consumption, Savings, and the Meaning of the Wealth Effect in General Equilibrium

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Consumption, Savings, and the Meaning of the Wealth Effect in General Equilibrium

Article excerpt

Over the latter half of the 1990s, the U.S. economy experienced both a substantial decrease in the savings rate and a significant run-up in household net worth. Between 1994 and 2000, the gross private savings rate fell from 17 to 12 percent, while the personal savings rate declined from above 6 percent to less than zero. Over the same period, the value of household sector equity holdings (including those owned by nonprofits, pensions, and other fiduciaries) increased nearly 150 percent for a dollar gain in excess of $6 trillion.

At some level, the decline in savings and the rise in household equity value during that period appeared to point towards a strengthening of the economy. According to the Permanent Income Hypothesis (PIH), households save less in a given period if they expect future increases in their income. Along these lines, the dramatic gain in stock market wealth was thought to partly reflect future opportunities made available to firms by rapid advances in information technology. Both the fall in savings and the rise in net wealth seemed consistent with the rapid growth of consumption during that period.

Despite the rosy outlook implied by the PIH at the close of the decade, the U.S. economy slowed down considerably in 2000. Specifically, the growth rate of per capita consumption fell to 2 percent in the first quarter of 2001 from nearly 7 percent in the same quarter of the previous year. Between the first quarter of 2000 and that of 2001, household net worth fell by 8 percent, or $3.5 trillion. In light of these developments, it seems only natural to question the significance of the data in the late 1990s. With this question in mind, this article seeks to emphasize the following points.

First, the PIH notwithstanding, a fall in savings today may not necessarily reflect expected future gains in income, but rather the current realization of a negative economic shock. Within the context of a simple neoclassical growth model with investment adjustment costs, we show that an unanticipated permanent fall in productivity leads to a contemporaneous fall in both consumption and savings. The fall in savings continues several periods into the future and a lower steady-state level of savings ultimately emerges. It remains true, in this model, that a fully anticipated increase in future productivity also leads to a contemporaneous fall in savings as households seek to smooth consumption. In the latter case, however, the savings rate eventually reaches a higher steady state level as the shock is realized.

Second, it is important to recognize that discussions of the wealth effect, such as those in Ludvigson and Steindel (1999) or Mehra (2001), are often carried out in a partial equilibrium setting. In such a setting, both the rate of interest and the level of wealth are exogenous with respect to contemporaneous consumption (i.e., wealth is a state variable). In contrast, general equilibrium considerations imply that wealth, the rate of interest, and consumption all contemporaneously react to the various disturbances affecting the economy. Thus, an unanticipated permanent increase in productivity leads to a simultaneous rise in both consumption and household net worth. Note, however, that consumption does not respond directly to wealth. Rather, both variables react simultaneously to the higher level of productivity. The implication of this dual reaction is that the measured marginal propensity to consume out of wealth is unlikely to be constant, as is often assumed. Indeed, empirical studies such as those in Mehra (2001) and Ludvigson and Steindel (1999) have found that the magnitude of the wealth effect is dependent on the sample period in question. This lack of time consistency in the wealth parameter would be expected if the nature of the shocks impacting the economy was changing over different sample periods.

In general, it can be misleading to think in terms of households' marginal propensity to consume out of wealth. …

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