This study measures the effect of changes in household net wealth on household consumption and is motivated by the sharp rise and fall in equity prices and the significant increase in property prices evident in Australia over recent years. The link between consumption, income and net wealth is measured via three alternate consumption functions based on varying degrees of wealth disaggregation. The consumption functions are estimated within a Dynamic Ordinary Least Squares and a Dynamic Generalised Least Squares framework originally proposed by Stock and Watson (1993). A robust long-run relationship is found in two of the three consumption functions for the period Q2: 1988-Q1:2003. Based on the empirical results, a one dollar increase in labour income is associated with a rise in consumption of between 84 to 90 cents, while a permanent one dollar increase in net wealth is associated with approximately a four cent rise in household consumption.
The contribution of this paper includes the disaggregation of the wealth effect for various components of household wealth, including housing, financial and superannuation wealth. The empirical results conclude that housing wealth has a greater effect on household consumption than financial wealth does. A one dollar increase in housing wealth leads to a six cent increase in consumption. In comparison, a one dollar rise in net financial wealth results in a two cent increase in consumption. Based on the estimated consumption functions, a policy experiment is conducted to quantify the effect of a fall in house prices on consumption. The house price fall is defined as the price movement required to re-align house values to a steady state valuation using a price-to-rental (PR) yield indicator. The required house price re-alignment would result in a fall in household consumption of up to 10.2 billion dollars, or approximately 1.4 per cent of Australia's annual Gross Domestic Product.