How does the real balance effect or wealth effect work?is when prices rise and purchasing power goes down,people feel poorer so they buy less?the theory says they feel poorer but that is not...

How does the real balance effect or wealth effect work?

is when prices rise and purchasing power goes down,people feel poorer so they buy less?the theory says they feel poorer but that is not nessarily true.is it?

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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To me, what the wealth effect is saying is that when people are wealthy, they spend more.  This is true even if their wealth isn't "liquid."  So what that means is let's say the stock market goes up.  I feel richer because I've got a lot of money in the stock market.  Now, I'm not really richer because I can't touch that money until I retire.

But still, I feel richer so I go out and spend more. When a bunch of people do that (because they feel richer), aggregate demand generally goes up.

The real balance effect does have to do with price levels.  But I would say that you really are poorer when price levels go up.  Your money will buy less.  That's why AD goes down in that case.

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