Tuesday, March 5

Understanding the Wealth Effect (2013 Edition)

What tool is available to a U.S. central banker who is faced with a) sluggish economy b) high unemployment c) and near-zero interest rates combined with d) an unwillingness to set negative nominal interest rates?

Enter the 'wealth effect'.

From Wikipedia:
The wealth effect is an economic term, referring to an increase in spending that accompanies an increase in perceived wealth. 
Consumption may be tied to relative wealth. People should spend more when one of two things is true: when people actually are richer, objectively, or when people perceive themselves to be richer—for example, the assessed value of their home increases, or a stock they own goes up in price.
Unfortunately or fortunately (depending on what side of the trade you're on), we've seen this story before and we very well know how it ends. The only question that we don't know the answer to is when will today's bubble turn to bust.

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