Question

what is the economic reasoning for the aggregate demand (and) function sloping downward from left to right showing an inverse relationship between the price level and real income (or output).

Answer 1

The aggregate demand curve slopes downward due to the wealth effect, the interest rate effect, and the foreign price effect, which all contribute to a decrease in aggregate demand as the price level rises.

Step-by-step explanation:

The aggregate demand (AD) curve is downward-sloping, indicating an inverse relationship between the price level and real income (output). This occurs due to three primary effects:

• The wealth effect: A higher price level decreases consumers' real wealth, which in turn lowers consumption.
• The interest rate effect: Increased price levels lead to a higher demand for money, pushing up interest rates and discouraging investment spending.
• The foreign price effect: Higher domestic price levels make local goods more expensive compared to foreign goods, reducing exports and increasing imports.

Despite these factors' contribution to the slope of the AD curve, economists often regard their impact as limited, hence, the curve is usually represented with a steep slope indicating a small change in aggregate demand relative to changes in the price level.