Which of the following explains the reasons for the downward slope of the aggregate demand curve?

• A. Increasing government spending and decreasing taxes
• B. The substitution effect and the income effect
• C. The law of diminishing marginal utility
• D. The wealth effect, the interest rate effect, and the exchange rate effect

Answer: (D)

Verified step by step guidance

1. Understand that the aggregate demand (AD) curve shows the relationship between the overall price level in the economy and the total quantity of goods and services demanded.
2. Recognize that the downward slope of the AD curve means that as the price level decreases, the quantity of aggregate demand increases, and vice versa.
3. Identify the three main effects that explain this negative relationship: the wealth effect, the interest rate effect, and the exchange rate effect.
4. The wealth effect explains that when the price level falls, the real value of money holdings increases, making consumers feel wealthier and thus increasing consumption.
5. The interest rate effect shows that a lower price level reduces the demand for money, leading to lower interest rates, which encourages more investment and consumption, while the exchange rate effect means that lower domestic price levels can lead to currency depreciation, making exports cheaper and increasing net exports.