The Aggregate Demand (AD) curve slopes downward, indicating that as the price level rises, the quantity of real GDP demanded falls. This inverse relationship arises from three key economic mechanisms: the wealth effect, the interest rate effect, and the exchange rate effect. These effects explain why lower prices stimulate demand across consumption, investment, and net exports, while higher prices dampen it.

Wealth Effect: This refers to how changes in the price level influence households’ real purchasing power and spending behavior.

• Lower price level: A decrease in prices increases the real value of money holdings, making consumers feel wealthier and boosting consumption (C).
• Higher price level: Rising prices erode purchasing power, reducing real wealth and leading to lower consumer spending.

Interest Rate Effect: Price level changes affect the demand for money, which in turn influences interest rates and borrowing for spending.

• Lower price level: Reduced prices lower the need for money transactions, increasing savings and the supply of loanable funds. This decreases interest rates, encouraging more borrowing for consumption (C) and investment (I).
• Higher price level: Increased prices raise money demand, reducing savings and pushing up interest rates. Higher rates discourage borrowing, curbing consumption and investment.

Exchange Rate Effect: Variations in domestic prices impact international competitiveness and trade balances.

• Lower price level: Cheaper domestic goods relative to foreign ones boost exports and reduce imports, increasing net exports (X – M).
• Higher price level: More expensive domestic goods lead to fewer exports and more imports, decreasing net exports (X – M).