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Why does the aggregate demand curve slope downward?
Three explanations for the negative slope are: 1. Interest rate effect 2. Real balance effect 3. Foreign purchases effect Aggregate demand (AD) is a curve showing the total amount of goods and services (real GDP) that will be purchased at different price levels. 1. Interest rate effect: As price level (P) rises, the real money supply (=nominal money supply/P) falls. This leads to an increase in interest rate. As interest rate rises, investment spending falls because of the increased cost of borrowing to finance investment. As investment falls, aggregate expenditure (AE) falls, in turn leading to a fall in real GDP (or Y). (Hence we see as P increases, Y decreases.) Try picturing this in terms of the IS-LM model too. The fall in the real money supply, which leads to an increase in interest rate, causes the LM curve to shift leftwards. Along an unchanged downward sloping IS curve, this results in a fall in equilibrium real GDP because of an upward movement** along the IS curve (**we say upward movement because as interest rate rises, investment spending falls, AE falls and hence real GDP falls). This confirms our conclusion that a rise in P leads to a fall in real GDP. NOTE: The interest rate effect is by far the dominant reason for a downward sloping AD curve. 2. Real balance effect (also known as real wealth effect or real money balances effect): It operates through consumption. As price level rises, purchasing power of money balances falls. As our real wealth falls, we will…

cut back on our consumption spending; hence autonomous consumption (Co) falls. This results in a decrease in AE and hence a decrease in real GDP. We can also picture this in terms of the IS-LM model. The fall in AE leading to a decrease in real GDP occurs at an assumed unchanged interest rate. This shifts the IS curve leftwards from IS(0) to IS(1). With an unchanged upward sloping LM curve, the fall in real GDP lowers transactions demand for money and hence total money demand (which comprises both transactions demand and asset demand components). This in turn lowers interest rate (that is, a downward movement along the LM curve). As interest rate falls, we know that investment spending will rise and hence AE and real GDP will rise (that is, a downward movement along IS(1)). [Of course, this rise in real GDP is not enough to offset the original fall in real GDP because to the downward sloping nature of the LM curve.] This ensures attainment towards simultaneous equilibrium in money market and output market. Overall, we trace that a rise in P leads to a fall in Co, AE, and hence Y. 3. Foreign purchases effect: It is applicable only to open economies with foreign trade being introduced into our explanation. With an increase in domestic price level relative to those of trading partners, domestic consumers will spend less on domestically produced goods and services and more on imports (M). Also, foreigners will buy less of our exports (X). The increase in M and decrease in X (that is, a decrease in net exports) means a decrease in real GDP. In terms of our IS-LM model, the decrease in net exports causes a fall in AE, a fall in real GDP and hence a leftward shift in the IS curve. With an unchanged LM curve, we notice an overall fall in both interest rate and real GDP (as we have explained in our “real balance effect”). It is conclusive that a rise in P leads to a fall in Y.



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