Aggregate Demand Curve

The aggregate demand curve shows the total quantity of real output that all sectors in an economy are willing to buy at different price levels, assuming other factors remain constant.

As the overall price level rises, the total quantity of real output demanded decreases. This inverse relationship results in a downward-sloping curve. The downward slope is explained by three key effects.

The first is the real balances effect, when prices rise, the value of money holdings falls. Households lose purchasing power, and spending declines.

The second is the interest rate effect. As the overall price level rises, people need more money to purchase high-cost items like homes or cars. But lenders have limited funds in the short run, so interest rates rise. Higher borrowing costs reduce overall spending in the economy.

The third is the net export effect, when domestic prices rise, goods from that country become more expensive for foreign buyers, while foreign goods become relatively cheaper. As a result, exports fall, and imports rise, reducing net exports.

Together, these effects explain why total output demand decreases as the overall price level increases.