Question

Each of the scenarios considers a change in the aggregate price level. Please indicate whether the scenario demonstrates the wealth effect (aka the real balances effect) or the interest rate effect. After an increase in the aggregate price level, Jasper realizes that the $300 in his checking account can now only buy as many lattes as $200 would have bought a year ago. As a result, he decides to purchase fewer lattes. Abe notices an increase in the aggregate price of goods during the three years he has been charting his costs. Due to the increase, he decides to use less of his money to finance investment spending for his business. Micah decides to increase savings in order to finance the remodeling of his home rather than seek a loan. Ivan notices a decrease in the aggregate price level of 10%, so he decides to spend more of his $3,500 in savings than he had originally planned to spend.

Answer 1

1. Wealth Effect as the increase in the price level lead to fall in the purchasing power of money.

2. Interest rate effect . A higher price level induces an increase in the interest rate which results in reduction of borrowing for consumption and investment expenditures.

3. Interest rate effect

4. Wealth Effect- With the decrease in the price level, the purchasing power of the money will rise. Thus, he will be able to purchase same amount at less expenditure and also save the residual amount.