Wealth effect: Evidence from threshold estimation

Several studies have examined the impact of changes in household wealth on consumption behavior. This is referred to as the wealth effect. This behavior depends upon the underpinnings of the life cycle theory, which predicts that households adjust their saving and wealth over time to keep their planned spending levels steady in the face of uneven income streams. Thus, an unexpected increase in wealth should stimulate consumers to spread it over the remainder of their lifetime, allowing a permanent increase in consumption.

This paper estimates the effect of changes in total wealth on the consumption behavior of households, taking into consideration the heterogeneity of households in income levels. This approach is in line with some studies that suggested that consumption behavior varies depending upon the income level of the household.

The issue in this kind of study is how to split the sample along the income levels. Instead of imposing an exogenous criterion for splitting the sample by income levels and estimating the wealth effect of each income category, this paper uses the threshold estimation technique developed in Hansen (1999). We use the threshold estimation technique to endogenously split the sample by income levels. The data are drawn from the Panel Study of Income Dynamics (PSID), during the waves of 2001, 2003, and 2005 to focus on the pre-financial crisis period. The results suggest that there are two significant threshold income levels of $130,100 and $403,500. Total wealth has an insignificant effect on consumption if income is below the first threshold $130,100. However, total wealth has a significant effect on consumption with a coefficient of 0.004050 if income is between $130,100 and $403,500. For income above $403,500, the coefficient is statistically significant with a coefficient of 0.001526.