Problem 13 Explain the importance of the re... [FREE SOLUTION]

Chapter 9: Problem 13

Explain the importance of the real balance, interest rate, and international trade effects to long-run (equilibrium) adjustment in the economy.

Short Answer

Expert verified

The real balance effect, interest rate effect, and international trade effect are important for long-run equilibrium adjustment in an economy. They work through channels of consumer spending, investment, and international trade to influence aggregate demand, thereby assisting an economy in returning to equilibrium following shifts in aggregate demand or supply.

Step by step solution

Understanding the Concept of Real Balance Effect

The real balance effect suggests that when there's an overall inflation or rise in price level, the purchasing power or real value of money held by households and businesses decreases. This is important in long-run equilibrium adjustment as it impacts consumer spending and saving which ultimately influences economic activity.

Understanding the Concept of Interest Rate Effect

The interest rate effect explains how changes in the price level impact interest rates, which subsequently influence investment and consumption spending. If the price level increases, individuals need more capital or money to finance their consumption or lending and saving activities, which pushes up the interest rate. This reduces investment and consumption, slowing down economic activity. Similarly, a lower price level results in a lower interest rate, encouraging investment and consumption, expanding economic activity.

Understanding the Concept of International Trade Effect

The international trade effect states that if the domestic price level rises relative to the price level in other countries, imports will increase and exports will decrease. On the other hand, if the domestic price level decreases relative to other countries, exports will increase and imports will decrease. The subsequent changes in net exports (exports - imports) affect the level of aggregate demand, leading to adjustments in the economy's long-term equilibrium.

Synthesizing the Effects to Long-run Equilibrium Adjustment

All these effects: Real balance, interest rate, and the international trade effect, play crucial roles in bringing an economy back to its long-run equilibrium after disturbances or shifts in aggregate demand or supply. They operate through various channels such as changes in real wealth, investment consumption, and net exports, impacting aggregate demand, and eventually bringing the economy back to a stable state.