when the cost of external finance depends on leverage, are likely to be reflected in q, making that variable endogenous to firm choice. In a related paper, Erickson and Whited (2000) point out that measurement error in q can lead to a positive relationship between a firm’s internal cash flow and its investment, even when there is no direct relation (which otherwise would suggest a deviation from the q model).

While results depend on methodology and data samples, empirical studies at the household level find significant wealth effects of asset prices on consumption. For the United States, estimates of the marginal propensity to consume (MPC) out of overall wealth (financial assets and illiquid assets, including housing) range between 4% and 7%. For financial wealth only, estimates for the United States suggest changes in consumption of the order of 0.03% to 0.07% for every 1% change in equity value.<sup>13</sup> Empirical estimates vary by country though. Bayoumi and Edison (2003) report that equity wealth effects are much weaker for countries other than the United States: for every 1% change in equity value, the change in consumption is 0.015% to 0.03% in Japan and 0.01% to 0.03% in various European countries. Others find long-run elasticities ranging from very small (or insignificant) to 0.35% on average for OECD countries (Catte et al (2004)).

The effects of asset prices also vary depending on financial market characteristics. In emerging market economies (EMEs), for example, wealth effects are small, possibly due to a limited and concentrated participation of households in capital markets. Slacalek (2009) reports an average wealth effect of 0.015% for a 1% change in equity value for 22 EMEs over 1985–2007. Funke (2004), in a study of 16 developing economies, reports that a 10% decline in annual real equity market return is associated with a reduction in real private consumption of about 0.2–0.4% on average.<sup>14</sup> Linkages between asset prices and macroeconomic outcomes also tend to vary by type of asset. In theory, housing wealth could have a smaller effect on consumption than equity market wealth because it is less clearly connected with future increases in productive potential (Mishkin (2007)). Moreover, since housing services are a component of consumption, increases in house prices can negatively affect consumption. At the same time, real estate wealth tends to be a significant share of households’ wealth and households can often borrow against this wealth and leverage the increase in house value for consumption purposes.

Both house and equity prices are much more volatile than output (Table 1A). House prices appear to be less volatile than equity prices, though, implying that changes in house prices are likely to be perceived more permanent than changes in equity prices (Cecchetti (2008)). Kishor (2007) reports that while 99% of the change in housing wealth is permanent, ie it remains after one quarter, only 46% of the change in equity wealth is. Housing also typically constitutes a larger share of total wealth, possibly making changes in house prices more important for household consumption decisions.<sup>15</sup>

> 13 For overall wealth estimates, see Gale et al (1999), Kiley (2000), Davis and Palumbo (2001), Barrell and Davis (2007a) and Case et al (2013). Using a broader definition of equity wealth (including both corporate equity and other types of security), the effect has been estimated at about 3 1/2 cents per dollar change in wealth (Ludvigson and Steindel (1999)).

> 14 See Kim (2004) for Korea, Peltonen et al (2012) for 14 EMEs, and IMF (2008) for cross-country evidence.

> 15 Lettau and Ludvigson (2004) also find that transitory shocks dominate variations in wealth in the United States while permanent shocks dominate variations in aggregate consumption, helping explain why little of the variation in household net worth relates to the variation in consumer spending. Kaplan et al (2014) find that households holding (illiquid) housing wealth behave like hand-to-mouth

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