Consumption and Stock Prices: Can We Distinguish Signalling from Wealth Effects?

There has been a resurgence of interest in the effect of stock price changes on the real economy in the wake of the long stock market boom of the 1990s and the subsequent correction starting in 2000. One of the primary variables linking the stock market and output is consumption expenditure, with the wealth effect being the traditional channel of influence. More recently a number of other channels have been identified, in particular the signalling channel which sees stock prices as having simply a leading indicator effect. However, there has been little work which disentangles these channels empirically. This paper makes a contribution to this question by distinguishing between the effects of changes in stock prices driven by fundamentals and those driven by speculation. Since these two components of stock prices cannot be observed they must be generated by a model, and we use a decomposition recently applied by Black et al. (2003). Since any decomposition is likely to be controversial we experiment with various alternative decompositions. We find that both components of stock prices influence consumption but that the fundamental component is consistently the least important, thus supporting the wealth rather than the signalling channel.