Question

What are the 3 reasons Aggregate Demand is downward sloping? Explain in your own words.

Answer 1

The 3 reasons Aggregate Demand is downward sloping are-

1) Wealth effect- Aggregate demand curve is drawn with the assumption of constant money supply. Money supply represents the wealth of the nation. As the price level rises, the purchasing power of money decreases, hence the wealth of the nation decreases, as it is measured by money supply. As the purchasing power and wealth decreases demand decreases.

2) Interest rate effect- As the price level rises, purchasing power decreases. Demand for money increases but supply is fixed. This causes the price of money (interest rate) to rise.As interest rate rises demand decreases as people want to invest money rather then spend it.

3) Exchange rate effect- As the domestic price level rises, the consumers find it relatively cheaper to import goods. So, imports rises. Also the for foreigners domestic goods are expensive so export falls. Net export( export-import) falls as export falls, import rises. Net export is a part of GDP. Since GDP falls, aggregate demand falls.