2.2.3Financial wealth and spending

In the rst part of this chapter, we saw that saving out of income enabled people

to add to their wealth. Saving would add to realwealth if it was used to nance

investment in real capital goods; saving would add to nancial wealth if it gave rise

to a nancial surplus. Clearly the decision to divide income between consumption

and saving is an important one and one which rms and households will take very

seriously. It seems reasonable to suppose that a household, for example, will have a

level of consumption which reects current income, and perhaps the income which

it expects to earn in future, as well as the ‘standard of living’ which is regarded as

normal for households with similar incomes, living in the same area and so on.

Cultural norms and traditions, as well as economics, play a part.

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2.3 The composition of aggregate demand

In addition to these factors, a household may have a target level of wealth.

This is a level of wealth which it wishes to accumulate, perhaps to pass to the next

generation, or to spend in retirement, or simply because it gives a sense of security

in an uncertain world. If a household is a long way from this target, therefore, it

seems reasonable to suppose that it will see saving (and consuming less) as a greater

priority than if it were near to its target. All this is just a way of saying that the

wealthier a household feels, the more inclined it will be to spend on consumption.

For any given level of income, therefore, consumption will be a higher proportion

of income when people feel ‘wealthy’.

As we have been pointing out since the beginning of this book, a major part

of people’s wealth consists of nancial assets of many kinds. As nancial wealth

increases, so too, other things being equal, does total wealth. Financial surpluses add

to nancial wealth, but nancial surpluses (and decits) are not the only reason for

changes in nancial wealth. We have noted already that many nancial assets are

traded in organised markets. Because they are traded, their price can go up and down.

As the price of tradable assets rises, the owners of those assets enjoy an increase in

nancial (and maybe total) wealth. If all our theorising is correct, we might then

expect that consumption will be positively affected (and saving negatively affected)

by price rises in asset markets. In October 1987, the price of ordinary shares in the

UK and US fell by approximately 30 per cent in just two days. Central banks around

the world reduced interest rates because they feared that this sharp drop in nancial

wealth would cause a fall in aggregate demand and the possibility of recession. The

same fears were revived exactly ten years later in the autumn of 1997, when prices

in South East Asian stock markets fell sharply. Prices elsewhere, however, were little

affected and by January 1999, shares on the New York exchange had doubled in

value since the middle of 1996. At the same time, aggregate household saving had

fallen to zero as US households went on a consumer boom, fuelled in part by this

unprecedented increase in nancial wealth.

In January 2001 the long stock-market boom came to an end in the UK and

the US. Over the next two years, the FTSE-100 index of stock prices fell by 50 per

cent. This caused a great deal of concern for people nearing retirement who were

relying on their nancial wealth to provide them with a future pension. It caused

a great deal of concern for pension funds which found they were committed to

paying pensions which theirinvestments could no longer support. Above all, it

caused a great deal of concern for the Bank of England (and the US Federal Reserve)

which both feared that the erosion of people’s wealth would lead them to cut

their consumption. For this reason, both central banks cut interest rates repeatedly

throughout 2001.