Question

Why does Aggregate-Demand (AD) curve slope downward? In your answer explain the effect of a higher price level on a) real interest rate and b) real exchange rate.

Answer 1

The reason why aggregate demand curve slope downward as the price level drops are as the price level drops ,the national income increases ,the first reason for downward slope of the aggregate demand curve is Pigou's wealth effect because for a given amount of money ,a lower price level gives more purchasing power per unit of currency thus a drop in price level induces consumers to spend more,there by increasing aggregate demand ,the other reason for downward slope of Aggregate demand is Mundell -Fleming exchange rate effect .When price level rises the interest rate also rises.When the domestic interest rate is high relative to the interest rate in foreign market forces foreign investors to invest in our country hence real exchange rate increases which lead to decline in export as net export is component of Aggregate demand then AD decrease hence slope is downward.