Wealth effects on consumption: evidence from the euro area

This paper estimates the wealth effects on consumption in the euro area as a whole. I show that: (i) financial wealth effects are relatively large and statistically significant; (ii) housing wealth effects are virtually nil and not significant; (iii) consumption growth exhibits strong persistence and responds sluggishly to shocks; and (iv) the immediate response of consumption to wealth is substantially different from the longrun wealth effects. By disaggregating financial wealth into its major components, the estimates suggest that wealth effects are particularly large for currency and deposits, and shares and mutual funds. In addition, consumption seems to be very responsive to financial liabilities and mortgage loans. Keywords: consumption, housing wealth, financial wealth. JEL Classification: E21, E44, D12. 4 ECB Working Paper Series No 1050 May 2009 Non-technical summary Conventional macroeconomic analysis typically includes wealth in models of output, income and prices’determination, namely, by considering that it impacts on both private consumption and money demand. Wealth can in‡uence economic activity through four major channels: (i) the (wealth) e¤ect on consumption, which is the focus of the present work; (ii) the Tobin’s Q e¤ect on investment, at it increases asset prices, reduces the cost of capital and, therefore, increases investment demand; (iii) the credit channel, by increasing the value of collateral (and, therefore, a¤ecting the balance sheets of households and …rms) and reducing the problem of adverse selection and the risk associated to investment; and (iv) the con…dence e¤ect on private spending. Household consumption is determined by income and asset wealth, namely, real estate and stock ownership. The positive impact on consumption due to the increase in housing wealth is called housing wealth e¤ect, whereas the e¤ect that is due to the increase in …nancial wealth is called …nancial wealth e¤ect. Authors have used di¤erent econometric techniques and databases to address the issue of wealth e¤ects on consumption. Nevertheless, the interest on the topic has recently revived as a consequence of the …nancial turmoil and the severe drop in housing prices. Not surprisingly, numerous academics, central banks and governments have started to question the potential macroeconomic implications of a downturn in house and equity prices. Although most of the empirical evidence refers to advanced economies and the US (mainly, due to the data availability), the existing literature on the impact of asset wealth ‡uctuations in the euro area is scarce or inexistent, despite its importance as a key engine of growth in the world. The main goal of this work is, therefore, to measure wealth e¤ects for the euro area as a whole. Using data at quarterly frequency and for the period 1980:1-2007:4, I show that: (i) …nancial wealth e¤ects are relatively large and statistically signi…cant; (ii) housing wealth e¤ects are virtually nil and not signi…cant; (iii) consumption growth exhibits strong persistence and responds sluggishly to shocks; and (iv) the immediate response of consumption to wealth is substantially di¤erent from the long-run wealth e¤ects. Looking at the composition of …nancial wealth, the estimates suggest that wealth e¤ects are particularly large for currency and deposits, and shares and mutual funds. In addition, consumption seems to be very responsive to …nancial liabilities and mortgage loans. 5 ECB Working Paper Series No 1050 May 2009