Question : The wealth effect suggests that an increase in the price level leads to:
Option 1: A decrease in consumption expenditure
Option 2: An increase in consumption expenditure
Option 3: A decrease in investment expenditure
Option 4: An increase in investment expenditure
Correct Answer:
A decrease in consumption expenditure
Solution : The correct answer is (a) A decrease in consumption expenditure.
The wealth effect suggests that an increase in the price level leads to a decrease in consumption expenditure. This effect occurs because as the price level rises, the purchasing power of individuals' wealth diminishes. In other words, their money can buy fewer goods and services.
When people perceive that their wealth has decreased in terms of real purchasing power, they tend to reduce their consumption expenditure. This is because they feel relatively poorer and have less disposable income available for spending. As a result, the overall level of consumption expenditure in the economy decreases.
