Why the AD Curve Slopes Down

Aggregate demand is the total spending on all domestic goods and services at each price level: consumption, investment, government spending, and net exports added together. As the price level rises, that total falls, and three separate channels explain why. Each one works through a different spending category, but all point the same direction.

The wealth effect hits consumption. People hold savings in fixed-dollar forms, like cash and bonds. When prices rise, that money buys less than it used to, so people feel poorer and spend less even if their income hasn't changed. The interest rate effect hits investment. A higher price level means people need more money on hand just to buy the same groceries and pay the same bills, so demand for money rises. The supply of money doesn't change just because prices did, so with more demand chasing a fixed supply, the interest rate gets bid up. Borrowing gets more expensive, so firms invest less and households finance fewer big purchases. The exchange rate effect hits net exports. Higher interest rates attract foreign investors seeking better returns, raising demand for the domestic currency and pushing up its value. A stronger currency makes exports pricier abroad and imports cheaper at home, so net exports fall.

All three effects feed into the same downward-sloping curve that this unit builds on: shift the curve with changes in expectations, foreign income, or government policy, and the economy slides along it whenever only the price level changes.