Why does an aggregate demand curve slope downward?

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In macroeconomics, aggregate demand (AD) is defined as the total demand for goods and services within a particular market, in a particular time. It is the total amount of goods and services that different economy sectors (individuals, firms, and the state) want and are ready to buy at a certain...

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In macroeconomics, aggregate demand (AD) is defined as the total demand for goods and services within a particular market, in a particular time. It is the total amount of goods and services that different economy sectors (individuals, firms, and the state) want and are ready to buy at a certain price level. The aggregate demand shows the connection between the amount of wanted goods and services and the overall price level in a certain economy, ceteris paribus. Aside from the price level, there are several other factors that can affect the aggregate demand, such as wealth, expectations, the value of the national currency, and the nation's fiscal, monetary, and income policy.

The aggregate demand is graphically shown with the aggregate demand curve. When the overall price level rises, the demand falls. In other words, when the price of the output goes down, potential consumers can buy goods and services that they couldn’t buy before. Thus, a downward sloping aggregate demand curve is produced. There are three main reasons for the downward slope of the aggregate demand curve: the wealth effect (Pigou), the interest rate effect (Keynes), and the exchange rate effect (Mundell-Fleming).

  1. The wealth effect: This shows how the variations in the average level of prices affect the real value of money and other forms of wealth. If the overall price level rises, the consumer’s purchasing power falls, thus decreasing the aggregate demand.
  2. The interest rate effect: When the overall price level increases, consumers’ savings decrease and consumers must spend more of their income to buy the same amount of goods and services. This affects the interest rate. When the interest rate rises, the demand for investment decreases, and the aggregate demand falls.
  3. The exchange rate effect: This shows how the variations in the overall price level affect the import and export of goods and services in the country. The rise of the overall price level makes the import of foreign goods and services cheaper and makes the export of domestic goods and services more expensive. As a result, the aggregate demand falls, and the aggregate demand curve slopes downward.
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There are two main reasons why the aggregate demand curve slopes downward.  First, there is the wealth effect.  An increase in the price level reduces people's real wealth as their money comes to have less value.  Therefore, they buy fewer things.  Second, there is the interest rate effect.  If prices go up, people and firms need to hold more money.  This means that less money is available to be lent.  When this happens, interest rates increase.  When interest rates increase, borrowing costs more and households are less likely to borrow in order to buy big ticket items.  This, too, leads to fewer things being bought.

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