Question

1. Until very recently, the stock market has been on the rise for the past several years. Households who own stocks (equities) in their retirement and other investment accounts felt wealthier and more confident about their future economic condition. How this phenomenon known as ‘the wealth effect’ affects the aggregate demand in an economy. Using an Aggregate-Demand/Aggregate-Supply graph demonstrate.

Answer 1

A wealth effect in the economy increase the consumer confidence and make them feel more secure resulting in an increased spending in the short run. This increased spending and confidence in the market will shift the aggregate demand curve to the higher output and higher price.

In the graph shown here, the economy was at equilibrium at point E1. After an increase in the consumer confidence due to the wealth effect, the demand increased and it shifted the AD curve to the AD2 fro Ad1. The output in the economy will increase and the price will be higher than before. The new equilibrium will be at the point E2.