Final answer:
The process by which lower overall prices in the economy lead to increased savings, higher supply of loanable funds, lower interest rates, and thereby higher consumption and investment is known as the interest rate effect. This effect is a fundamental component of why the aggregate demand curve is downward sloping, and the correct option for the question presented is (d) the interest rate effect.
Step-by-step explanation:
The Interest Rate Effect Explained
When prices in the economy fall overall, households will tend to have larger savings as their demand for money falls. This will increase the supply of loanable funds, which lowers interest rates. Lower interest rates encourage both consumption and investment by making borrowing more attractive. This is because businesses will find it cheaper to finance new investments and consumers will find it more economical to borrow for big-ticket purchases such as homes and cars. This mechanism, part of the reason why the aggregate demand curve is downward sloping, is best described as the interest rate effect.
The aggregate demand (AD) curve represents the total quantity of all goods and services demanded by the economy at different price levels. The downward slope of the AD curve can be attributed to three primary reasons: the wealth effect, the interest rate effect, and the foreign price effect. However, in this particular scenario, the most relevant is the interest rate effect because it directly relates to changes in interest rates affecting consumption and investment components of aggregate demand.
Thus, in response to the question, the correct option for why aggregate demand is downward sloping when overall prices fall is (d) the interest rate effect.