Wealth Effect

Examples of Wealth Effect in the following topics:

• The Slope of the Aggregate Demand Curve

  • Due to Pigou's Wealth Effect, the Keynes' Interest Rate Effect, and the Mundell-Fleming Exchange Rate Effect, the AD curve slopes downward.
  • As a result of Keynes' interest rate effect, Pigou's wealth effect, and the Mundell-Fleming exchange rate effect, the AD curve is downward sloping.
  • In the context of the above discussion on Keynes, Pigou's Wealth Effect underlines the fact that liquidity traps are not sustainable.
  • The simplest way to explain the Wealth Effect is that an increase in spending will denote an increase in wealth.
  • The analysis of interest rates displayed above, through the wealth effect in particular, offsets the negative spiral that could occur as a result of deflation and decreased employment.

• The Importance of Aggregate Decisions about Consumption versus Saving and Investment

  • In order to understand the effects of aggregate decisions of consumption, savings, and investment, we must look at aggregate demand (AD).
  • The aggregate demand curve is downward sloping but in variation with microeconomics, this is as a result of three distinct effects: the wealth effect, the interest rate effect and the exchange-rate effect.
  • The wealth effect is specifically related to the value of assets; market participants will adjust consumption in-line with their perception of the appreciation or depreciation of held assets (a home; equity investments, etc.).
  • The interest rate effect has to do with access to inexpensive funding, which provides an incentive to increase current period expenditures; while the exchange-rate effect has to do with expenditure decisions related to imports or foreign related expenditures, as the exchange rate is perceived to be favorable to the domestic currency, expenditures on foreign items or imports will increase.

• Impacts of Policies and Events on Equilibrium

  • Changes in prices can shift aggregate demand, and therefore the macroeconomic equilibrium, as a result of three different effects:
  • The wealth effect refers to the change in demand that results from changes in consumers' perceived wealth.
  • Since inflation causes real wealth to shrink and deflation causes real wealth to increase, the wealth effect of inflation will cause lower demand and the wealth effect of deflation will cause higher demand.
  • The interest rate effect refers to the way in which a change in the interest rate affects consumer spending.
  • Analyze the effects that events and policies can have on economic equilibrium

• Impact of Income on Consumer Choices

  • The simplest way to demonstrate the effects of income on overall consumer choice, from the viewpoint of Consumer Theory, is via an income-consumption curve for a normal good(see ).
  • The wealth effect differs slightly from the income effect.
  • The wealth effect reflects changes in consumer choice based on perceived wealth, not actual income.
  • As a result, it is useful to outline the differences in income effects on normal, inferior, complementary and substitute goods:
  • Break down changes in consumption into the income effect and the wealth effect

• Distribution Effects of Inflation

  • Unexpectedly high inflation tends to transfer wealth from creditors to debtors and from the rich to the poor.
  • When inflation is expected, it has few distribution effects between borrowers and lenders.
  • Since it benefits debtors and hurts creditors, in practice unexpected inflation is often a transfer of wealth from the rich to the poor .

• The Costs of Inflation

  • The costs of inflation include menu costs, shoe leather costs, loss of purchasing power, and the redistribution of wealth.
  • Shoeleather cost refers to the cost of time and effort that people spend trying to counteract the effects of inflation, such as holding less cash, investing in different currencies with lower levels of inflation, and having to make additional trips to the bank.
  • The effect of inflation is not distributed evenly in the economy, and as a consequence there are hidden costs to some and benefits to others from this decrease in the purchasing power of money.
  • When prices are rising quickly, people will buy durable and nonperishable goods quickly as a store of wealth, to avoid the losses expected from the declining purchasing power of money.

• GDP per capita

  • GDP per capita is often used as average income, a measure of the wealth of the population of a nation, particularly when making comparisons to other nations .
  • It is easily calculated from readily-available GDP and population estimates, and produces a useful statistic for comparison of wealth between sovereign territories.
  • Without using measures of income adjusted for inflation, they will tend to overstate the effects of economic growth.

• Colonization

  • The colonists were left to build their own lives, their own communities, and their own economy -- in effect, to start constructing the rudiments of a new nation.
  • In addition, fishing was a primary source of wealth in Massachusetts.
  • By the 18th century, regional patterns of development had become clear: the New England colonies relied on ship-building and sailing to generate wealth; plantations (many using slave labor) in Maryland, Virginia, and the Carolinas grew tobacco, rice, and indigo; and the middle colonies of New York, Pennsylvania, New Jersey, and Delaware shipped general crops and furs.

• The Functions of Money

  • Difficulty storing wealth: If society relies exclusively on perishable goods, storing wealth for the future may be impractical.
  • Analyze how the characteristics of money make it an effective medium of exchange

• How Income is Allocated

  • However, economists view the impact of technological progress to outweigh the effect of globalization, as technology has effectively been substituted for more expensive wage labor.
  • In the U.S., recent studies have stated that the wealthiest 400 Americans control nearly 50% of domestic wealth.