How can the downward-sloping AD curve be explained?

The downward-sloping aggregate demand (AD) curve in economics can be explained by three main effects that link the overall price level to the quantity of goods and services demanded within an economy:

1. Wealth Effect (Real Balances Effect)

When the price level falls, the real value of money (or purchasing power) in consumers' hands increases because they can now buy more goods and services with the same amount of money. This increased purchasing power boosts household consumption, which is a significant component of aggregate demand. As the price level rises, the opposite occurs: the real value of money decreases, reducing purchasing power and, in turn, lowering consumption and aggregate demand.

2. Interest Rate Effect

The interest rate effect occurs because lower price levels often lead to lower interest rates. Here’s how:

• When prices drop, consumers and businesses may need to hold less money for transactions, freeing up more funds in banks and financial institutions.
• This surplus of funds tends to reduce interest rates, making borrowing cheaper.
• Lower interest rates encourage businesses to invest more and households to spend more on large items (such as homes or cars), thereby increasing aggregate demand.
• Conversely, when price levels rise, interest rates tend to increase, discouraging borrowing and spending, which reduces aggregate demand.

3. Exchange Rate Effect (International Trade Effect)

A lower domestic price level can make a country’s goods relatively cheaper on the international market:

• As prices fall, foreign buyers find domestic goods more affordable, leading to an increase in exports.
• Additionally, domestic consumers are likely to reduce their purchases of relatively more expensive imported goods, substituting them with cheaper local alternatives.
• This increase in exports and reduction in imports raise net exports (exports minus imports), thus boosting aggregate demand.
• On the other hand, if the domestic price level rises, exports become less competitive, imports become more attractive, and net exports fall, which lowers aggregate demand.

Summary of the Effects

The downward slope of the AD curve results from the combination of these three effects:

• Wealth Effect increases demand as price levels drop.
• Interest Rate Effect encourages more investment and consumption when interest rates fall.
• Exchange Rate Effect boosts demand through increased exports and reduced imports at lower price levels.

Each effect reinforces the inverse relationship between the price level and the quantity of output demanded, which gives the AD curve its downward slope.