Question

Which of the following reasons does not contribute to the downward slope of the Aggregate Demand (AD) curve?

As the price level increases, what typically happens?
a) Wealth effect
b) Interest rate effect
c) Foreign exchange effect
d) Substitution effect

Answer 1

The substitution effect does not contribute to the downward slope of the AD curve. The wealth effect, the interest rate effect, and the foreign exchange effect are the three primary reasons behind the sloping nature of the AD curve.

Step-by-step explanation:

The reason that does not contribute to the downward slope of the Aggregate Demand (AD) curve is (d) the substitution effect.

The downward-sloping AD curve can be attributed to three main reasons:

• (a) The wealth effect: This posits that an increase in the price level decreases the real wealth of consumers, thus reducing their consumption and contributing to a downward-sloping AD curve.
• (b) The interest rate effect: As prices rise, the demand for money increases, leading to higher interest rates, which in turn discourages investment and consumption.
• (c) The foreign exchange effect: A higher domestic price level makes a country's goods more expensive relative to foreign goods, thus reducing exports and decreasing the quantity of domestic goods demanded.

While all three effects are subject to debate among economists, they are generally accepted as the reasons why the AD curve tends to slope downwards.