The Wealth Effect in Empirical Life-Cycle Aggregate Consumption Equations

Abstract

The application of cointegration and error correction methodology to estimate aggregate consumption equations relating consumer spending to labor income and household wealth shows unequivocally that wealth has significant effect on consumer spending. Still, the long-term marginal propensity to consume out of equity values is low, indicating that a 1 dollar increase in equity values raises consumption by 3 to 4 cents. Given the explosion in equity values in the 1990s, however, the magnitude of the consumption effect is substantial, adding on average 1 percentage point to the annual growth rate of real GDP since 1995. Wealth does have predictive content for future consumption, indicating that a persistent decline in equity wealth may lead to lower consumer spending.