Why the aggregate demand curve slopes downward The following graph shows the aggregate demand (AD) curve in a hypothetical economy. At point A, the price level is 120, and the quantity of output demanded is $500 billion. Moving up along the aggregate demand curve from point A to point B, the price level rises to 140, and the quantity of output demanded falls to $300 billion.

As the price level rises, the cost of borrowing money will (fall/remain the same/rise), causing the quantity of output demanded to (fall/remain the same/rise).

This phenomenon is known as the (exchange rate/Interest rate/wealth) effect.

Additionally, as the price level rises, the impact on the domestic interest rate will cause the real value of the dollar to (rise/fall) in foreign exchange markets. The number of domestic products purchased by foreigners (exports) will therefore (fall/remain the same/rise), and the number of foreign products purchased by domestic consumers and firms (imports) will (fall/remain the same/rise). Net exports will therefore (fall/remain the same/rise), causing the quantity of domestic output demanded to (fall/remain the same/rise). This phenomenon is known as the (exchange rate/Interest rate/wealth) effect.

1. As the price level rises, the cost of borrowing money will rise, causing the quantity of output demanded to fall.

This phenomenon is known as the Interest rate effect.

When price levels rise, people will have to spend more on goods and services and hence save less. As they save less there'll be less loanable funds in the economy which will force interest rates (cost of borrowing) up. As there are less loans to give out and higher rates, people will borrow less and as a result will not demand as much because they can't afford it.

2. Additionally, as the price level rises, the impact on the domestic interest rate will cause the real value of the dollar to rise in foreign exchange markets. The number of domestic products purchased by foreigners (exports) will therefore fall, and the number of foreign products purchased by domestic consumers and firms (imports) will rise. Net exports will therefore fall, causing the quantity of domestic output demanded to fall. This phenomenon is known as the exchange rate effect.

As interest rates rise in the Economy, it will make the country a more attractive place to invest for foreigners so they will demand more of the local currency. This will cause a rise in the value of the domestic currency. This will make the exports of the country more expensive so less people outside will buy it but it will also make foreign products seem cheaper so the local consumers will import more.

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