It seems both logical and intuitive that if the price level falls, consumers and businesses will increase their demand for goods and services. That's the general idea behind the downward slope of the aggregate demand curve. There is, however, a far more interesting story to tell here about this downward slope that involves some key principles of macroeconomics. So take a look at this figure, which shows the AD curve as a schedule of price quantity combinations. Here, we see the various amounts of real output that domestic consumers, businesses, the government, and foreign buyers of exports, will collectively desire to purchase at each possible price level, holding other things constant. Now, here's a quick digression and varied key concept. The "Holding Other Things Constant" is a frequent assumption in economics, and it is also referred to by its Latin name, Ceteris Paribus. By holding other things constant, economists are able to isolate specific effects. In the context of aggregate supply and demand, the Ceteris Paribus Assumption will allow us to isolate the reasons why the AS or AD curves might shift inward or outward in their two dimensional representation. For example, consider this representation of the aggregate demand curve in our two dimensional graph. To draw this curve, we must hold a bunch of things constant, like, the wealth of consumers, the interest rates businesses might pay on new investment, and the value of the exchange rate governing trade in imports and exports. I suppose we want to represent a change in one of these other things. Suppose for example, the income of consumers rises. How you think that might affect aggregate demand, and how would we represent that in this figure? Let's pause now as you ponder that, and then jot down your answer. Take a crack at this before moving on. The answer is that, aggregate demand curve will shift outward to AD star. This is because with more wealth, consumers are likely to spend more, and thereby, increase aggregate demand. Now, let's get back to our story about why the aggregate demand curve slopes downward. At this point, try to think of some more specific reasons for the downward sloping curve, and take a minute to jot down some of your ideas before we move on. Okay, here are three technical reasons why the aggregate demand curve slopes downward, and they are all well-worth grasping. The first reason for a downward slope in AD curve is due to a real balance effect, or wealth effect. Specifically, as the price level falls, the purchasing power of consumers actually increases. To see this, suppose you have $30000 in cash, that gives you a certain amount of purchasing power at today's prices. For example, that car you might want to buy might listed $40000, and is out of your price range, so you don't buy it. But then, suppose the price level falls for some reason, stay a steep recession in the economy that causes such deflation. Now, that car might only cost $25,000, and you can afford to buy it because your purchasing power has increased. That's the wealth effect part of the downward sloping aggregate demand curve. A second reason why the aggregate demand curve slopes downward is in interest rate effect. As the price level falls, so, too, may interest rates. In such a case, falling interest rates will in turn increase investment spending by businesses. At the same time, lower interest rates may stimulate more consumer spending on interest rate sensitive items, such as, automobiles and housing, which are typically purchased with the help of loans and mortgages, which become less expensive as interest rates fall. The third reason the aggregate demand curve slopes downward is a net export effect, also called, the foreign purchases or foreign trade effect. Let's explain this net export effect by posing these three questions. One, if the domestic price level falls, will the domestic demand for foreign imports rise or fall? Two, will the demand from foreigners for a country's exports rise or fall? And three, what will be the net effect on net exports and aggregate demand? Take a minute now to jot down your answer before moving on. This is a cool puzzle well worth solving. So, what happens to imports and exports if the domestic price level falls? For starters, domestic consumers will find foreign imports to be relatively more expensive. So, they buy less, and import demand falls. At the same time, domestic exports will be relatively more cheap for foreigners to buy, so they buy more and export demand rises. Now, as imports fall and exports rise, net exports increase. And this likewise implies a downward sloping aggregate demand curve, and that's the net export effect. So together, the wealth effect, the interest rate effect, and the net export effect, all indicate a downward sloping aggregate demand curve. In the next module, we will get back to the idea of why the aggregate demand curve also shifts inward and outward in response to changes in the macro-economy. This is where things really get useful from a business and investor point of view. So, let's move on when you're ready.
