Three essays on wealth effect

Abstract

We first clarify that changes in fundamental paper wealth are wealth redistributions between current and future asset owners; and increases in fundamental paper wealth tend to make current consumers wealthier and hence have positive impacts on current aggregate consumption. Based on the concept of fundamental paper wealth, we examine three issues related to asset prices. The first issue is related to the wealth effect of monetary policy. While the wealth and Tobin's q effects are usually treated as two independent monetary policy transmission mechanisms, we show that they are indeed negatively correlated under a general-equilibrium perspective; and their magnitudes depend upon investment elasticity. These insights provide a new perspective to the relationship between asset prices and monetary policy. Another issue is related to the capital account policy of developing countries. Empirical evidence shows that capital inflows are often used by developing countries to finance excessive consumption. While the existing literature generally explains these phenomena as resulting from institutional imperfections, we show that they can be the results of fundamental paper wealth effect caused by capital inflows. We show that, while risk aversion causes low investment elasticity and hence reduces the total benefit of capital account liberalization for society over time, it nevertheless tends to make current consumers better off and drive consumption booms. We show that a positive yet uncertain future productivity shock is likely to cause consumption booms because of sluggish investment reactions. The third issue is related to the "asset market meltdown hypothesis", which predicts that baby boomers' prime-time savings will drive up asset prices that will eventually collapse due to their retirement dissavings. While the existing literature generally supports the hypothesis, we find that the meltdown is actually state-contingent and may not necessarily happen because the large capital stock built up by baby boomers' large savings may be able to sustain the asset prices during baby boomers' retirement era. However, we find that, in the case where the meltdown is about to happen, baby boomers as a whole has no escape; and their attempts to escape could push the economy into a liquidity trap.