Question

5. Fully explain why economy's aggregate demand curve has a negative slope. an

Answer 1

First of all, Aggregate Demand is the summation of Consumption expenditure, Investment expenditure, government expenditure, and net exports.

AD = C + I + G + NX

The AD curve is drawn on a C2 plane with a GDP level on the X-axis and Price on the Y-axis. The negative relationship between GDP and the price level leads to downward sloping AD curve.

An increase in the price level reduces the consumer's real wealth and consumption expenditure. This is popularly known as Pigou's Wealth Effect.

Also, an increase in the price level will raise the money demand and the interest rates will rise. As there exists inverse relationship between the interest rate and investment, the overall investment level starts decreasing. This is known as the Interest Rate Effect as suggested by JM Keynes.

As home products become relatively expensive due to the increase in the price level, the foreign demand for domestically produced goods will also decrease. Home currency appreciation will occur. This is known as the Exchange Rate Effect proposed by Mundell and Fleming.

So, we see that an increase in the price reduces C, I, G, NX. Hence, the AD will fall with an increase in the price level and the curve is downward sloping.