What is AD? Why the Aggregate Demand Curve is Downward Sloping?

Answer : Aggregate demand is an economic measurement of the total amount of

demand for all finished goods and services produced in an economy .Aggregate
demand over the long-term equals [GDP] because the two metrics are calculated in the
same way. GDP represents the total amount of goods and services produced in an
economy while aggregate demand is the demand or desire for those goods. As a result
of the same calculation methods, the aggregate demand and GDP increase or decrease
together
We have to analyze how to price level affects the quantity of goods and services
demanded for consumption, investment and net exports. By doing so, we can identify
three distinct but related reasons why the aggregate demand curve is downward
sloping: (1) the Wealth Effect, (2) the Interest Rate Effect, and (3) the Exchange Rate
Effect.
1. The Wealth Effect
A decrease in the price level makes consumers wealthier, which increases consumer
spending. The reason for this is that the real value of money depends on its buying
power and not on its nominal value (i.e., the face value). That means when prices fall,
consumers can afford to buy more goods and services with the same amount of money.
This increase in wealth encourages them to spend more, which in turn increases the
aggregate quantity of goods and services demanded.
To give an example, let’s look at an imaginary country called Somolland. Somolland has
100 inhabitants. Each of them has USD 10.00 in their pockets. For the sake of this
example, we’ll assume that there is only one product sold in Smolland: ice cream. One
ice cream cone costs USD 2.00 (P1 in the illustration above). That means each
inhabitant can buy 5 cones, and aggregate demand adds up to 500 cones (Y1).
However, if the price of ice cream falls to USD 1.00 (P2), each inhabitant can buy 10
cones with the same USD 10.00 they had before. Thus, they become more wealthy ,
and the aggregate quantity demanded increases to 1,000 cones (Y2).

2. The Interest Rate Effect

A decrease in the price level lowers the interest rate, which increases investment
spending by businesses as well as consumer spending. The reason for this is that the
quantity of money demanded is dependent on the price level. That means when the
price level falls, consumers need less currency to buy the goods and services they want
so they can keep a larger share of their money in the bank. The bank then uses these
funds to make more loans, which drives the interest rate down, and vice versa.
A lower interest rate reduces the cost of investments, which increases investment
spending by businesses. In addition to that, it may also encourage consumer spending
on interest rate sensitive goods, such as cars or housing, which are typically purchased
with the help of loans or mortgages, respectively.
To illustrate this, let’s revisit Smolland. This time, however, we’ll assume that people
don’t have to spend all their money on consumption. Instead, they can deposit a share
of their funds in savings accounts. At the original price of USD 2.00 per cone, the
consumers buy 500 cones, which adds up to USD 1000. Thus, in the initial scenario,
they don’t deposit any money in the bank. However, if the price falls to USD 1.00,
people can buy the same amount of ice cream for half the price (i.e., 500 cones x USD
1.00 = USD 500) and deposit the other half of their money in the bank (i.e., USD 500).
The bank can then use that money to make a loan to the ice cream seller, which allows
the latter to invest in additional equipment and increase their production capabilities.

3. The Exchange Rate Effect

A decrease in the domestic price level lowers the value of the local currency, which
increases net exports. The reason for this is that the low domestic price level causes the
local interest rate to fall (see above). Whenever that happens, domestic investors tend
to shift their investments to foreign countries with higher interest rates to get a better
return. This shift causes the real exchange rate to depreciate because the international
supply of the local currency increases.
When the real exchange rate falls, domestic consumers will find that imports become
relatively more expensive. So they buy less from abroad, and imports decrease.
Meanwhile, domestic exports become relatively cheaper for foreigners to buy, so
exports increase. As a result, net exports rise, which increases the quantity of goods
and services demanded.
In the case of Smolland, we can illustrate this by introducing a second country. Let’s say
people can get the same ice cream from another imaginary country in Europe. We’ll call
it Coneland. Now, assume the price level (and thereby the interest rate)
in Smolland decreases. This causes investors from Smolland to shift some of their
investments to Coneland. However, to do that, they have to exchange some of their
USD to EUR. This increases the international supply of USD, which causes the
currency to depreciate. As a result, it becomes relatively cheaper for people
from Coneland to buy ice cream from Smolland and relatively more expensive for
people from Smolland to buy ice cream from Coneland. Hence, the real exchange rate
decreases and net exports rise.