Chapter 24: Problem 23

What are the economic reasons why the AD curve slopes down?

Short Answer

Expert verified

The downward slope of the Aggregate Demand (AD) curve is attributed to three main economic reasons: the wealth effect, the interest rate effect, and the international trade effect. The wealth effect refers to the impact of the price level on consumer purchasing power, with lower price levels leading to increased consumption due to higher perceived wealth. The interest rate effect illustrates how changes in price level influence interest rates, affecting investment and consumption spending. Lower price levels cause lower interest rates, stimulating aggregate demand. The international trade effect explains how domestic price levels influence exports and imports: lower domestic prices lead to increased exports and reduced imports, boosting aggregate demand. Hence, these combined effects result in the AD curve's downward slope.

Step by step solution

1. Understand the wealth effect

The wealth effect refers to the impact of the overall price level on consumer purchasing power, which in turn affects the quantity of goods and services demanded in the economy. When the price level falls, consumers feel wealthier as their purchasing power increases, leading them to buy more goods and services. Conversely, as price levels rise, the purchasing power of consumers decreases, and they demand less goods and services. This results in the downward slope of the AD curve.

2. Understand the interest rate effect

The interest rate effect explains how changes in the price level impact the interest rates in an economy, which in turn affects the overall aggregate demand. When the price level falls, people require less money to buy goods and services which leads to a decrease in the demand for money. Consequently, the interest rates fall, resulting in a lower cost of borrowing for businesses and consumers. This stimulates investment and consumption expenditure, thereby increasing aggregate demand. On the other hand, when the price level rises, the demand for money increases, leading to an increase in interest rates. This discourages investment and consumption, resulting in a lower aggregate demand and contributing to the downward slope of the AD curve.

3. Understand the international trade effect

The international trade effect is the impact of the price level on imports and exports, and thus on aggregate demand. When the domestic price level falls relative to the price levels in other countries, domestic goods and services become relatively cheaper for foreign buyers, increasing exports. At the same time, foreign goods and services become relatively more expensive for domestic consumers, leading to a decrease in imports. The net effect is that aggregate demand for domestic goods and services increases. The opposite occurs when the domestic price level rises relative to other countries, resulting in a decrease in aggregate demand. This effect further contributes to the downward slope of the AD curve.

Conclusion

The AD curve slopes downwards due to the combined effects of the wealth effect, the interest rate effect, and the international trade effect. All three of these economic reasons explain why a lower price level leads to an increase in aggregate demand for goods and services in an economy, while a higher price level results in a decrease in aggregate demand.

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