Why does an aggregate demand curve slope downward?

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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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.