Asset Prices and Monetary Policy: Wealth Effects on Consumption

The aim of this paper is to test a model explaining private consumption as a function of income and wealth (financial assets plus real estate), with data from European Union (EU) countries. We know that income explains a large part of consumption as well as wealth, but concerning the effects of the latter, mainly those of changes on financial asset prices, few is known for Europe. In a general way, and according to the literature, wealth effects are less significant in continental Europe, due to the less advanced financial deregulation degree and household stock ownership, when compared with the USA or the United Kingdom. On the other hand, housing wealth effects on consumption would be more pronounced in Europe. To examine how recent developments in stock markets and housing prices may have affected consumption behaviour, we consider for the different countries a set of consumption equations that include variables related to asset prices. After studying the variables’ stationarity properties, we estimate a model with a common error-correction formulation, with the long-run relationship having terms in the variables for which we found significant cointegrating vectors nested in a short-run equation. We found an implied elasticity of consumption with respect to real equities prices at around two per cent and, when there is available data, an implied elasticity of consumption with respect to real residential prices between ten and twenty per cent. This weak effect of stock prices on consumer spending is broadly consistent with life cycle saving and a modest wealth effect. Nevertheless, it is still worthy to do a further study of the effects of stock market and residential wealth (and its fluctuations) on consumption and output of the different countries. The complete study of those differences and its magnitude is important even for the definition of the monetary policy by the European Central Bank (ECB) and to answer the question if it should consider asset prices in its decisions. The research presented here is a first essay preceding a deeper work on this subject, concerning economies of the EU. After this exercise we think that there is scope for future analysis on this matter that attempts to better explain the connection between asset prices and consumer spending.