3 REASONS FOR A DOWNWARD–SLOPING AGGREGATE DEMAND CURVE

The aggregate demand curve shows the inverse relationship between pro d level and the demand for a country's GDP.

Aggregate demand cures are always downward-sloping indicating the law of demand.

But, Why are aggregate demand curves downward sloping? 

There are three reasons for this: the wealth effect, the interest rate effect, and the foreign exchange effect.

1. Wealth effect: The first reason why the aggregate demand curve is downward-sloping is the wealth or real-balances effect.

A higher price level will reduce the purchasing power of money and other financial assets available to the public.

By eroding the purchasing power of such assets, the public will be poorer in real terms and, therefore, will reduce its spending. 

Because consumption expenditure is a component of aggregate demand, the quantity of aggregate demand will reduce.

By the same logic, a decrease in the price level will increase the quantity of aggregate demand.

To understand the wealth effect, let consider the following scenario. Let say you have €10000 in cash and the price level increases by 10 percent. 

Because the price of the goods and services you could have purchased with your €10,000 have potentially increased by 10%, your money is now worth 10% less.

To put it in another way, Your money's purchasing power (value) has decreased by 10%.

The main point here is that when the price level increases, the real value of wealth increases. This drop-in real wealth leads to a decrease in consumption, which in turn leads to a decrease in aggregate demand.

To summarize, there is an inverse relationship between the price level and output because of the real wealth effect.

2. Interest rate effect: Another reason why the aggregate demand curve is downward sloping is the interest rate effect. 

When the price level rises, consumers will have to spend more money on goods that were previously sold for a low price. This will, of course, increase the demand for money.

And because the supply of money is fixed, this increase in demand for money will increase the price of money. And that price is, of course, interest rates.

A higher interest rate will result in a decrease in consumer and business spendings as consumers and businesses reduce their interest-sensitive expenditures. 

Because consumer spending and business spending are major components of aggregate demand, aggregate demand will decrease.

By the same reasoning, a fall in the price level will result in a decrease in interest rates, which, will increase consumer and business spending. 

And as consumer and business spending increase, so does aggregate demand.

The main point here is that an increase in the price level will increase the demand for money, which will reduce consumption and investment. 

These decreases in consumption and investment spending will eventually lead to a decrease in aggregate demand

To sum it up, the interest rate effect asserts that there is an inverse relationship between the price level and real output because of the interest rate.

3. Foreign trade effect: The third reason for a downward sloping aggregate demand curve is the foreign trade effect or international effect.

To better understand the foreign trade effect, let use the example of a hypothetical country named "smalland". 

As the price level in smalland increases, the goods and services of small and become more expensive to foreigners. As a result, they will buy less from smalland, resulting in a decrease in smalland's export.

At the same time, foreign goods will be cheaper to smalland citizens who tend to buy more products from other countries As a result, smalland's import increases.

What this means is that net export will be negative and aggregate demand will be reduced.

The opposite is true when the price level falls: imports will be relatively expensive while exports will be cheaper. This means net export will be positive and aggregate demand will increase.

Therefore, if the price level rises (assuming the foreign exchange rate is constant), net exports and aggregate demand will decreases. A fall in the price level, on the other hand, will result in a rise in net exports and aggregate demand.

Therefore, the foreign effect explains that the reason why price level and real output are inversely related is due to the foreign trade


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