Explain the reasons why the AD curve slopes downward

Question

What will be an ideal response?

Answer 1

There are two reasons why the AD curve slopes downward: the wealth effect and substitution effects.
The wealth effect points out how changes in the price level cause changes in the real value of wealth. Price increases decrease real wealth and so people consume less in order to increase their wealth through saving. As a result, an increase in the price level decreases the aggregate quantity of goods and services demanded.
There are two substitution effects. The first is the intertemporal substitution effect: an increase in the price level raises the interest rate because the amount of real loans banks can make decreases. The higher interest rate leads consumers to decrease their consumption expenditure and firms to decrease their investment spending. The second substitution effect is the international price substitution effect: an increase in the U.S. price level raises the price of U.S.-made goods relative to foreign-made goods. So people and firms decrease the quantity of U.S.-made goods they purchase and increase the quantity of foreign-made goods they purchase. So both substitution effects also lead to a rise in the price level decreasing the aggregate quantity demanded.