Why the Aggregate Demand Curve is Downward Sloping

Updated Jun 26, 2020

To understand why the aggregate demand curve is downward sloping, we have to look at the relationship between the price level and the components of GDP (see also how to calculate GDP). More specifically, we have to analyze how the price level affects the quantity of goods and services demanded for consumption, investments, and net exports. By doing so, we can identify three distinct but related reasons why the aggregate demand curve is downward sloping: (1) the Wealth Effect, (2) the Interest Rate Effect, and (3) the Exchange Rate Effect. We will look at each of them in more detail below.

1. The Wealth Effect

A decrease in the price level makes consumers wealthier, which increases consumer spending. The reason for this is that the real value of money depends on its buying power and not on its nominal value (i.e., the face value). That means when prices fall, consumers can afford to buy more goods and services with the same amount of money. This increase in wealth encourages them to spend more, which in turn increases the aggregate quantity of goods and services demanded.

To give an example, let’s look at an imaginary country called Smolland. Smolland has 100 inhabitants. Each of them has USD 10.00 in their pockets. For the sake of this example, we’ll assume that there is only one product sold in Smolland: ice cream. One ice cream cone costs USD 2.00 (P1 in the illustration above). That means each inhabitant can buy 5 cones, and aggregate demand adds up to 500 cones (Y1). However, if the price of ice cream falls to USD 1.00 (P2), each inhabitant can buy 10 cones with the same USD 10.00 they had before. Thus, they become more wealthy, and the aggregate quantity demanded increases to 1,000 cones (Y2).

2. The Interest Rate Effect

A decrease in the price level lowers the interest rate, which increases investment spending by businesses as well as consumer spending. The reason for this is that the quantity of money demanded is dependent on the price level. That means when the price level falls, consumers need less currency to buy the goods and services they want so they can keep a larger share of their money in the bank. The bank then uses these funds to make more loans, which drives the interest rate (i.e., the price of the loan) down, and vice versa (see also the law of supply and demand). A lower interest rate reduces the cost of investments, which increases investment spending by businesses. In addition to that, it may also encourage consumer spending on interest rate sensitive goods, such as cars or housing, which are typically purchased with the help of loans or mortgages, respectively.

To illustrate this, let’s revisit Smolland. This time, however, we’ll assume that people don’t have to spend all their money on consumption. Instead, they can deposit a share of their funds in savings accounts. At the original price of USD 2.00 per cone, the consumers buy 500 cones, which adds up to USD 1000. Thus, in the initial scenario, they don’t deposit any money in the bank. However, if the price falls to USD 1.00, people can buy the same amount of ice cream for half the price (i.e., 500 cones x USD 1.00 = USD 500) and deposit the other half of their money in the bank (i.e., USD 500). The bank can then use that money to make a loan to the ice cream seller, which allows the latter to invest in additional equipment and increase their production capabilities.

3. The Exchange Rate Effect

A decrease in the domestic price level lowers the value of the local currency, which increases net exports. The reason for this is that the low domestic price level causes the local interest rate to fall (see above). Whenever that happens, domestic investors tend to shift their investments to foreign countries with higher interest rates to get a better return. This shift causes the real exchange rate (i.e., the relative price of domestic and foreign goods and services) to depreciate because the international supply of the local currency increases.

When the real exchange rate falls, domestic consumers will find that imports become relatively more expensive. So they buy less from abroad, and imports decrease. Meanwhile, domestic exports become relatively cheaper for foreigners to buy, so exports increase. As a result, net exports (i.e., exports – imports) rise, which increases the quantity of goods and services demanded.

In the case of Smolland, we can illustrate this by introducing a second country. Let’s say people can get the same ice cream from another imaginary country in Europe. We’ll call it Coneland. Now, assume the price level (and thereby the interest rate) in Smolland decreases. This causes investors from Smolland to shift some of their investments to Coneland. However, to do that, they have to exchange some of their USD to EUR. This increases the international supply of USD, which causes the currency to depreciate. As a result, it becomes relatively cheaper for people from Coneland to buy ice cream from Smolland and relatively more expensive for people from Smolland to buy ice cream from Coneland. Hence, the real exchange rate decreases and net exports rise.

Summary

To understand why the aggregate demand curve is downward sloping, we have to analyze how the price level affects the quantity of goods and services demanded for consumption, investments, and net exports. By doing so, we can identify three distinct but related reasons why the aggregate demand curve is downward sloping: The Wealth Effect, the Interest Rate Effect, and the Exchange Rate Effect. The Wealth Effect states that a decrease in the price level makes consumers wealthier, which increases consumer spending. The Interest Rate Effect states that a decrease in the price level lowers the interest rate, which increases investment spending by businesses as well as consumer spending. Finally, the Exchange Rate Effect states that a decrease in the domestic price level lowers the value of the local currency, which increases net exports.