What is the Real Balance Effect?
- The change in consumption caused by a change in the real value of financial assets
- When prices rise, like during inflation, people’s purchasing power goes down because money is worth less
- When prices fall, then people’s purchasing power goes up because their money allows them to buy more
Life Application/Analogy
Pretend that you have $10, and your favorite drink costs $2 each, so you can only buy 5 of them. However, if the price were to drop to $1 and you still have only $10, you can now buy 10 of them instead. So your purchasing power went up although your income did not change at all, and that’s the real balance effect.
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