Question

3. Suppose that all households hold all their wealth in assets that automatically rise in value when the aggregate price level rises (an example of this is what is called an "inflation-indexed bond"—a bond whose interest rate, among other things, changes one-for-one with the inflation rate). What happens to the wealth effect of a change in the aggregate price level as a result of this allocation of assets? Will aggregate demand still be downward sloping? Why or why not?

Answer 1

Answer:

What happens to the wealth effect of a change in the aggregate price level as a result of this allocation of assets?

• The consumers' wealth effect will rise since the slope of the aggregate demand curve increases as the prices of assets increases, i.e. the slope of the aggregate demand curve becomes steeper as customers become wealthier.

Will aggregate demand still be downward sloping? Why or why not?

• The aggregate demand curve sill still be downward sloping because as the price of a good or service increases, the quantity demanded will still decrease. An inverse relationship exists between price changes and quantity demanded.