How do asset prices affect the economy

Economy is the financial structure of any country, simply put. The stronger economy is visible in the form of confidence of foreign investors, quality lifestyle of the citizens and increased buying power. Asset price is an important indicator of pace of economic development in any country. It can affect the economy of the country through following ways:

Wealth Effect

Wealth effect means that consumers tend to increase expenditure in response to increase in the underlying value of their assets. 

Let’s understand its effect on economy through an example. Investment in a low cost real estate inventory that converts into a high end property over the time can make owners millionaires. This substantial increase in wealth directly influences the buying power. They start searching for high value properties where they can invest the money earned from trading. They stop minding spending money on good food, good clothes, and in upgrading lifestyle overall. In short, rise in wealth leads to household consumptions.

This on a macro level creates expansion opportunities for businesses that are directly associated with the life of the individual having more spending power. So, some immediate changes observed due to wealth effect are:

a. Banks are able to provide more mortgage to the customers who display high value asset pool in their ownership. It leads to ease of spending on cars, and other luxuries that ultimately create demand and earning opportunities for the sellers who contribute to economy significantly. 

b. Increase in tax from the Government in the form of stamp duty is another effect that ultimately strengthens the revenue part. The Government sees the opportunity to raise taxes that ultimately boosts the revenue collection. It, in the long run, enables the Government to take decisions in the direction of economy boost.

This effect is visible largely in stock and housing sectors. However, rise in wealth due to rise in stock is not a sustained rise, it may not let owners feel financially secure for longer time. It is the rise in property price that is capable of changing the face of economy of any country.

Transmission Effect

Transmission effect is more like a ripple effect. Certain monetary policy decisions taken at the Central Bank level in a country can show its impact on all pillars of economy coming in their immediate influence. When the wealth due to asset price appreciation increases in the hands of the owners, they need a banking system to deposit the surplus. If we consider it happening on a large scale, it leads to more fund flowing into the banking system. 

The Central bank takes into consideration the changes happening at the consumer level. It, then, modifies the monetary policy basis which the banks redesign their lending rate and interest rate structures. The change in interest rate shows its long term effect in the form of inflation in a span of 2-3 years. This change in interest rate is the second stage of transmission effect that actually emanates from the first stage which is change in cash flow rate, which we have already discussed is the outcome of appreciation in asset price.

Transmission effect takes time to seep into the household level. The change in behavior of the household entities does not happen overnight. They couple the possibilities of stable income flow with the new found surplus wealth in hand in order to take decisions related to upgradation of lifestyle.

Thus, asset price can affect important indicators of economy which are cash flow, consumption and demand cycle and investment channel. All these ultimately show the impact on currency value at the exchange rate channel. The low currency value can make imports expensive that can again affect the economy when placed in a larger picture.

Tobin’s Q effect

Tobin’s Q is an important economists’ term. It is valuation of any firm’s asset value with respect to its market value. Tobin's Q = Total Market Price of Firm / Total Asset Price of Firm. This ratio called Q’s ratio helps in determining the selling cost of any asset and the appreciation/loss arising from the transaction. Investors take help of this ratio to find if any asset is overvalued or undervalued. Less than 1 Tobin’s Q indicates undervalued asset. Thus, the investors show interest in such asset in the hope of earning huge margin off it in future.

Any asset or company having Tobin’s Q more than 1 gives rise to competition in the market. Instead of buying an overvalued company or firm, a business tries to erect a contemporary rival to this company and pull the market share in its favor. This leads to more production, diversification of offerings, segmentation of users and so on. All these changes reflect in the way economy strengthens or weakens over a period of time in following pattern:

a. Overvalued company lead to introduction of a new similar company

b. The products start flowing in more in comparison with the demand

c. This leads to reduction in price of the product

d. It, as a result, increases the buying power of the consumer

e. Finally, leading to more savings, better GDP and ultimately stronger economy.

The factor of inflation can disrupt this sequence at various points making it difficult for the people to witness any direct influence on economy immediately and clearly. Still, it is an effect that shows impact on economy in a longer time span.

Confidence effect

Asset price gives way to confidence effect on the status of economy. A high asset price makes people feel secure financially. They feel stable about their economic state. This ultimately increases the buying power and household consumptions leading to positive impact on the demand-supply ratio which is crucial for determining the economic state of any country. 

When the asset price is quite high, the owner is able to maintain the expenditure irrespective of growing inflation. Thus, high confidence of earners in an economy is an indication of growing economy, and the reverse shows that economy of a country is declining. On a larger scale, the country with stagnant or laid back economy will not be able to attract foreign investors and it will also hit the exchange rate.

So, these are the four important effects through which asset price shows its impact on economy of any country.