Why is the AD curve downward sloping?

The AD curve is downward sloping due to the wealth effect, interest rate effect, and the international trade effect.

The Aggregate Demand (AD) curve, which represents the total demand for goods and services in an economy at different price levels, is downward sloping. This means that as the price level falls, the quantity of goods and services demanded increases, and vice versa. There are three main reasons for this negative relationship between price level and aggregate demand: the wealth effect, the interest rate effect, and the international trade effect.

The wealth effect refers to how a change in the price level affects the purchasing power of money. When the price level falls, the real value or purchasing power of money increases. This means that consumers can buy more goods and services with the same amount of money, leading to an increase in consumption and hence aggregate demand. Conversely, when the price level rises, the real value of money falls, reducing consumption and aggregate demand.

The interest rate effect is about how a change in the price level affects the demand for money and hence interest rates. When the price level falls, people need less money to buy goods and services. This reduces the demand for money, leading to a fall in interest rates. Lower interest rates encourage investment and consumption, both components of aggregate demand. On the other hand, when the price level rises, the demand for money increases, pushing up interest rates and discouraging investment and consumption.

The international trade effect explains how a change in the price level affects net exports. When the domestic price level falls relative to the price level in other countries, domestic goods and services become cheaper for foreign consumers. This leads to an increase in exports and a decrease in imports, boosting net exports and hence aggregate demand. Conversely, when the domestic price level rises relative to other countries, exports fall and imports rise, reducing net exports and aggregate demand.

In summary, the AD curve is downward sloping because a fall in the price level increases the real value of money (wealth effect), lowers interest rates (interest rate effect), and improves net exports (international trade effect), all of which increase aggregate demand. Conversely, a rise in the price level has the opposite effects, reducing aggregate demand.