Assess the likely macroeconomic effects of an increase in house prices on the UK economy

An increase in house prices is likely to cause a wealth effect in the UK economy. The wealth effect is defined as an increase in consumer expenditure when their portfolio performance is high. In this case, households will consume more and save less, due to an increase in confidence. As the diagram shows, aggregate demand (AD) increases, and the curve (AD1) shifts to the right. The new aggregate demand curve is at AD2, with an increase in real output to Y2 from Y1, and price level to P2 from P1. The increase in real output translates into a faster rate of economic growth in the UK economy. The AD1 to AD2 shift is likely to be large, as consumption makes up around 63% of the aggregate demand equation. With faster economic growth, the UK economy is closer to full employment. There could be a futher increase in aggregate demand if investment from the UK construction industry increases, again due to confidence. However, the wealth effect could be regional. Greater government expenditure and rapid gentrification in London could result in a larger wealth effect in this region of the UK. Therefore, overall aggregate demand for the UK may not increase by as much, as the wealth effect may be asymmetric across regions. Here, the wealth effect would be difficult to determine on a macroeconomic basis. Also, if the UK has spare capacity in their economy, the impact of a wealth effect on the real output level is much lower. Spare capacity measures the extent to which an economy is performing below the maximum level of production, and how far the economy is to full employment. As the second diagram shows, an increase in aggregate demand from AD3 to AD4 , with an intersection on the more elastic part of the aggregate supply (AS) curve, leads to a higher increase in real output from Y3 to Y4. Therefore, the level of spare capacity in the UK economy will ultimately determine the impact of the wealth effect on the UK's rate of economic growth.