Why does the AD curve slope downward?
3 reasons: 1. Real Balance Effect – as the price level increases, the purchasing power of money declines. When the price level decreases, the purchasing power of money increases. There is an inverse relation between real wealth and the price level. We assume that you are holding some of your wealth in the form of cash. If you have $20,000 under your mattress, or in the bank, and prices double, the value of your cash decreases by 1/2. You are worse off and would reduce your spending, a negative wealth effect. If all prices are cut in half, your cash is now worth twice as much. Because lower price levels increase the value of wealth in the form of cash holdings, you spend more when price levels fall because of the positive wealth effect. This contributes to an inverse relationship between the Price Level and Real GDP. 2. Interest Rate Effect – When the price level falls, people and businesses don’t need as much cash to carry out transactions. Disposable income can only go to C + S. If C
