Why does the AD curve slope downwards?
There are several explanations for an inverse relationship between aggregate demand and the price level in an economy. These are summarised below: • Falling real incomes: As the price level rises, so the real value of people’s incomes fall and consumers are then less able to afford UK produced goods and services. • The balance of trade: As the price level rises, foreign-produced goods and services become more attractive (cheaper) in price terms, causing a fall in exports and a rise in imports. This will lead to a reduction in trade (X-M) and a contraction in aggregate demand. • Interest rate effect: if in the UK the price level rises, this causes an increase in the demand for money and a consequential rise in interest rates with a deflationary effect on the entire economy. This assumes that the central bank (in our case the Bank of England) is setting interest rates in order to meet a specified inflation target. Shifts in the AD curve A change in factors affecting any one or more compo
