Question

In the context of aggregate demand and aggregate supply, the wealth effect refers to the idea that when the price level decreases, the real wealth of households:

a) Increases, and as a result, consumption spending increases. This effect contributes to the downward slope of the aggregate-demand curve.

b) Decreases, and as a result, consumption spending increases. This effect contributes to the upward slope of the aggregate-supply curve.

c) Increases, and as a result, households increase their money holdings; in turn, interest rates increase, and investment spending decreases. This effect contributes to the downward slope of the aggregate-demand curve.

d) Decreases, and as a result, households increase their money holdings; in turn, interest rates increase, and investment spending decreases. This effect contributes to the upward slope of the aggregate-supply curve.

Answer 1

The wealth effect refers to the diminished purchasing power of people's savings when the price level increases, leading to lower consumption and a downward movement along the aggregate demand curve.

Step-by-step explanation:

The wealth effect is a key concept in understanding the downward slope of the aggregate demand (AD) curve in the context of aggregate demand and aggregate supply economics. It asserts that as the price level increases, the real value of household savings and wealth decreases. This reduction in purchasing power due to inflation means that individuals feel less wealthy and therefore, they are likely to decrease their consumption spending. As consumption is a major component of aggregate demand, a fall in consumption spending leads to a downward movement along the AD curve.

This change in consumption behavior due to variations in the price level can impact the economy significantly. Lower consumption can result in reduced aggregate demand, less economic output, and potentially influence decisions on investment, driven by the interest rate effect. When aggregate demand decreases, it can lead to an economic downturn, making the wealth effect a critical aspect for economists and policymakers to consider.