In Figure 12-1, the curve AD is downward sloping. Why? Recall the basic equation of national income accounting:

where C is consumer spending, I is investment spending, G is government purchases of goods and services, X is exports to other countries, and IM is imports. If we measure these variables in constant dollars—that is, in prices of a base year—then C + I + G + X − IM is the quantity of domestically produced final goods and services demanded during a given period. G is decided by the government, but the other variables are private-sector decisions. To understand why the aggregate demand curve slopes downward, we need to understand why a rise in the aggregate price level reduces C, I, and X − IM.

You might think that the downward slope of the aggregate demand curve is a natural consequence of the law of demand we defined back in Chapter 3. That is, since the demand curve for any one good is downward sloping, isn’t it natural that the demand curve for aggregate output is also downward sloping? This turns out, however, to be a misleading parallel. The demand curve for any individual good shows how the quantity demanded depends on the price of that good, holding the prices of other goods and services constant. The main reason the quantity of a good demanded falls when the price of that good rises—that is, the quantity of a good demanded falls as we move up the demand curve—is that people switch their consumption to other goods and services.

But when we consider movements up or down the aggregate demand curve, we’re considering a simultaneous change in the prices of all final goods and services. Furthermore, changes in the composition of goods and services in consumer spending aren’t relevant to the aggregate demand curve: if consumers decide to buy fewer clothes but more cars, this doesn’t necessarily change the total quantity of final goods and services they demand.

Why, then, does a rise in the aggregate price level lead to a fall in the quantity of all domestically produced final goods and services demanded? There are two main reasons: the wealth effect and the interest rate effect of a change in the aggregate price level.

The Wealth Effect An increase in the aggregate price level, other things equal, reduces the purchasing power of many assets. Consider, for example, someone who has $5,000 in a bank account. If the aggregate price level were to rise by 25%, what used to cost $5,000 would now cost $6,250, and would no longer be affordable. And what used to cost $4,000 would now cost $5,000, so that the $5,000 in the bank account would now buy only as much as $4,000 would have bought previously. With the loss in purchasing power, the owner of that bank account would probably scale back his or her consumption plans. Millions of other people would respond the same way, leading to a fall in spending on final goods and services, because a rise in the aggregate price level reduces the purchasing power of everyone’s bank account.

Correspondingly, a fall in the aggregate price level increases the purchasing power of consumers’ assets and leads to more consumer demand. The wealth effect of a change in the aggregate price level is the effect on consumer spending caused by the effect of a change in the aggregate price level on the purchasing power of consumers’ assets. Because of the wealth effect, consumer spending, C, falls when the aggregate price level rises, leading to a downward-sloping aggregate demand curve.

The Interest Rate Effect Economists use the term money in its narrowest sense to refer to cash and bank deposits on which people can write checks. People and firms hold money because it reduces the cost and inconvenience of making transactions. An increase in the aggregate price level, other things equal, reduces the purchasing power of a given amount of money holdings. To purchase the same basket of goods and services as before, people and firms now need to hold more money. So, in response to an increase in the aggregate price level, the public tries to increase its money holdings, either by borrowing more or by selling assets such as bonds. This reduces the funds available for lending to other borrowers and drives interest rates up.

In Chapter 10 we learned that a rise in the interest rate reduces investment spending because it makes the cost of borrowing higher. It also reduces consumer spending because households save more of their disposable income. So a rise in the aggregate price level depresses investment spending, I, and consumer spending, C, through its effect on the purchasing power of money holdings, an effect known as the interest rate effect of a change in the aggregate price level. This also leads to a downward-sloping aggregate demand curve.

We’ll have a lot more to say about money and interest rates in Chapter 15 on monetary policy. We’ll also see, in Chapter 19, which covers open-economy macroeconomics, that a higher interest rate indirectly tends to reduce exports (X) and increase imports (IM). For now, the important point is that the aggregate demand curve is downward sloping due to both the wealth effect and the interest rate effect of a change in the aggregate price level.