I’m aware that in basic economics class one of the explanations for the downward-sloping Aggregate Demand Curve is the wealth effect or Pigou effect, which means that as price level goes down, your perceived real wealth increases, increasing consumption.
However, I got stuck when I learned that, according to my professor, “wealth effect was created to explain why people might increase spending when price levels go down, which couldn’t be explained by the Consumption model, which is a function of disposable income only.”
Why can’t “income” explain how people might increase their consumption when prices go down? There is the “income effect” we learn in microeconomics right? It is almost the same concept as the wealth effect - that when the price of a good goes down your real income - your purchase power increases so you increase consumption of that good. Of course if you go down to the minute details income is a ‘flow’ concept and wealth being ‘stock’, so there are subtle differences, but in the end they explain the same thing - consumption increases when prices go down, because your real wealth or real disposable income increases.
So my main question is, why do you need another concept such as the “wealth effect” to explain why people increase spending when price levels go down, when there is already a very similar concept (income effect) that also perfectly explains the same thing? Why can’t you just use “income effect” instead of “wealth effect” to explain the downward-sloping AD curve? I’m wondering why the concept of wealth effect exists at all when there is already a very similar concept explaining the same actions of economic agents....
