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

O ver 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