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

Empirical studies of the consumption-wealth relationship often assume a framework in which aggregate household spending depends linearly on wealth, the underlying state variable. These studies have given rise to many estimates of the wealth effect. In a general equilibrium setting, however, both consumption and wealth react to shocks impacting the economy. Therefore, without any independent movements in wealth, the marginal propensity to consume out of wealth is not well defined. Clarification of this point necessitates a study of the relationship between consumption, savings, and equity within the framework of a real business cycle model with investment adjustment costs. The study shows that the behavior of consumption and wealth depends crucially on the nature of the shocks affecting households and firms. The form of the shocks and whether they are anticipated alter not only the magnitude of the wealth effect but also the direction of the response. That is, in the context of this conventional model, net worth and consumption may actually move in opposite directions. In light of these findings, it may be unrealistic to expect estimates of the wealth effect made over long periods of time to be stable indicators for the behavior of current or future consumption