Financial innovation and the effect of housing wealth on consumption

The recent strong growth of house prices in many countries and the turbulence on the US sub-prime mortgage markets have highlighted the need for policy-makers to understand the links between fi nancial markets and the real economy. A key channel operates through the effect of financial and housing assets on personal consumption. The importance of this channel is determined by the institutional structure of financial markets. Financial innovation lowers transaction costs and leads to the reduction of credit constraints. A priori, these two elements affect the size of the wealth effect in opposite directions, so the overall outcome can be determined only by means of empirical analysis. Available research suggests that the sensitivity of personal consumption to wealth shocks, particularly shocks in housing wealth, has risen over time. This trend is likely to continue in the future. JEL Classification: E21, E32, C22