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LAFFER CURVE: The graphical inverted-U relation between tax rates and total tax collections by government. Developed by economist Arthur Laffer, the Laffer curve formed a key theoretical foundation for supply-side economics of President Reagan during the 1980s. It is based on the notion that government collects zero revenue if the tax rate is 0% and if the tax rate is 100%. At a 100% tax rate no one has the incentive to work, produce, and earn income, so there is no income to tax. As such, the optimum tax rate, in which government revenue is maximized, lies somewhere between 0% and 100%. This generates a curve shaped like and inverted U, rising from zero to a peak, then falling back to zero. If the economy is operating to the right of the peak, then government revenue can be increased by decreasing the tax rate. This was used to justify supply-side economic policies during the Reagan Administration, especially the Economic Recovery Tax Act of 1981 (Kemp-Roth Act).
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                           FINANCIAL WEALTH, AGGREGATE DEMAND DETERMINANT: One of several specific aggregate demand determinants assumed constant when the aggregate demand curve is constructed, and that shifts the aggregate demand curve when it changes. An increase in financial wealth causes an increase (rightward shift) of the aggregate curve. A decrease in financial wealth causes a decrease (leftward shift) of the aggregate curve. Other notable aggregate demand determinants are interest rates, federal deficit, inflationary expectations, and the money supply. Household wealth comes in two basic forms--physical wealth and financial wealth. Financial wealth includes money, bank accounts, stock certificates, bonds, and other financial instruments that provide direct or indirect claims on physical goods. Physical wealth consists of houses, cars, land, property, furniture, appliances, and the whole array of satisfaction-generating physical goods.The key with financial wealth is that it can be used to acquire physical wealth. In financial lingo, financial wealth tends to be liquid, it can easily flow between assets. Corporate stock, government savings bonds, and money market bank accounts can all easily flow into money. This money can then flow into, or be used to buy, corporate stock, government savings bonds, and money market bank accounts. Or, more importantly for this present discussion, this financial wealth can flow into, or be used to buy, physical wealth, including houses, cars, land, property, furniture, appliances, and the whole array of satisfaction-generating physical goods. Changes in financial wealth, as such, tend to cause consumption expenditures to change in the same direction. - If households have more financial wealth, then they are able to buy more goods.
- If households have less financial wealth, then they are able to buy as fewer goods.
A change in the financial wealth, by changing consumption expenditures, induces changes in aggregate demand. An increase in financial wealth increases aggregate demand and a decrease in financial wealth decreases aggregate demand.| Shifting the Curve |  |
This exhibit to the right displays a common aggregate demand curve. Like all aggregate demand curves, this one is constructed based on several ceteris paribus aggregate demand determinants, such as financial wealth. The key question is: What happens to the aggregate demand curve if financial wealth changes?More Financial WealthSuppose, for example, that the stock market has been rising steadily for several years. This means that the value of corporate stock has risen, providing shareholders with an increase in financial wealth. These shareholders could simply hold onto their more valuable financial wealth, or they could "cash it in," using the money to purchase physical assets. The result is that this increase in financial wealth causes an increase in consumption expenditures and subsequently an increase aggregate demand.To see how an increase in financial wealth affects the aggregate demand curve, click the [More Wealth] button. The increase in financial wealth triggers an increase in aggregate demand, which is a rightward shift of the aggregate demand curve. Less financial WealthAlternatively, suppose that the stock market has been falling steadily for several years (or even a few months). This means that the value of corporate stock has fallen, causing the financial wealth of shareholders to decline. Because these shareholders now have less financial wealth, they are less able to purchase physical assets. In fact, some might be forced to sell off existing physical assets if they borrowed the funds used to purchase the corporate stock. The result is that the decrease in financial wealth causes a decrease in consumption expenditures and subsequently a decrease in aggregate demand.To see how a decrease in financial wealth affects the aggregate demand curve, click the [Less Wealth] button. The decrease in financial wealth triggers a decrease in aggregate demand, which is a leftward shift of the aggregate demand curve. What Does It Mean?Changes in financial wealth as an aggregate demand determinant can play havoc with the economy. The best example of this is the Great Depression of the 1930s. While a significant business-cycle contraction was already underway, the stock market crash of October 1929 caused an enormous decrease in financial wealth that triggered a decrease in aggregate demand, which undoubtedly contributed to the severity of the Great Depression.While the ups and downs of the stock market tends to get the most notoriety when the topic turns to financial wealth as an aggregate demand determinant, financial wealth takes many forms. And in the study of macroeconomics the most important form it takes is money.
Recommended Citation:FINANCIAL WEALTH, AGGREGATE DEMAND DETERMINANT, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: April 22, 2024].
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Lewis Carroll, the author of Alice in Wonderland, was the pseudonym of Charles Dodgson, an accomplished mathematician and economist.
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MPC
Marginal Propensity to Consume
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