Question

What are the economic reasons why the AD curve slopes down?

Short answer

The AD curve slopes down due to the wealth effect, exchange rate effect, and interest rate effect

Step-by-step solution

Concept introduction

Aggregate demand is the total demand for all commodities by various entities in an economy.

Pigou's wealth effect is when prices fall, employment rises as wealth rises.

Keynes' Interest Rate Effect is fluctuations in interest rates have an effect on goods market spending as a result of price changes.

Mundell-Fleming's exchange effect is that the impact of any economic policy is determined by the government's exchange rate system.

Explanation

The reasons for the lower slope of the aggregate demand curve are -

• Pigou’s wealth effect: The price level determines the true value of money. The real value of money decreases as the price level rises. People spend less in such circumstances. Similarly, as the price level declines, people's purchasing power rises, causing them to spend more and thereby increasing aggregate demand.
• Keynes’s interest rate effect: The amount of money demanded is proportional to the price level. It means that if the price level rises, more money will be required to purchase goods and services. As a result, when the economy's price level is higher, consumers demand more money.
• Mundell-Fleming’s exchange rate effect: The interest rate declines with the price level. When the interest rate in a local country is lower than in a foreign country, domestic investors are more willing to invest in foreign countries since they would earn a higher return. As a result, when the domestic currency flows to foreign, the real exchange rate lowers. As domestic items and services become more affordable, the net export grows as the exchange rate falls. As a result, an increase in net export improves aggregate demand.