AD curve is downward sloping because of the reverse relationship between price and spending (AD).

Why AD curve slopes downward ? or Why aggregate demand for output falls at higher aggregate price?

PRICE LEVEL

P1

P2
AD

Y1

Y2

Aggregate Output

Real Balance Effect:

With rise in general price level, the real value of monetary asset will fall making people feel poorer than before.

Resultantly, they will consume less therefore demand will go down as well AD slopes downward.

Rate of Interest Effect:

At a higher price level, people will require more money for purchasing and transaction purpose. This will lead to the increase in the demand for money for transaction. At given the money supply, increase in demand of money will cause the rate of interest to go up. At higher rate of interest, demand for investment in new capital goods (machinery, plant , equipment) will decline. Resultantly AD will go down . Hence slope of AD is downward .

Foreign Trade effect :

The rise in general price level will lead to decline in export which reduces income and whereby aggregate demand curve slopes downward.

Increase in imports because of fall in price of imported products will lead decline in demand . for domestic products.

There is direct relationship between price rise and aggregate supply.

Short run AS comprising of three stages:

AS

Vertical range

Intermediate Range Price Level Horizontal Range Capacity Output

AS
Y Aggregate Output YF

1.

Horizontal Range:

As per Keynes, in horizontal range of output upto Y, the economy can expand its production without facing rise in unit cost of production because at this time economy is in the grip of recession with high unemployment and unutilized machinery. Since other resources are lying unused resultantly there will not be higher cost per unit or rise in the price level if aggregate output is expanded in the range.

In depression while product prices and wages are inflexible downward it is real output will fall and AS Will be horizontal.

Intermediate Range

In this range (between Y and YF) increase in aggregate output brings about rise in price level, whereby AS curve is upward sloping. Because: As national production expands some industries, like electronics and computer hardware may experience shortage of skilled engineers. Due to shortage of engineers for some crucial industries bottleneck in production may arise which will push up the cost in these industires whereby price level upward.

In order to overcome shortage of skilled labour less skillful workers may be employed resulting in rise in unit cost of production.
Before full employment of resources, some industries may experience shortage of raw material due to expansion of production encounters rising unit cost of production. Most important factor cost is the decline in factor of labour as employed in expanding responsible for rising marginal products of more of them are production.

Vertical Range:
As per classical economist In this range, AS is perfectly inelastic or vertical at the full employment level of output (YF)

Vertical shape of AS curve implies that any further rise in the price level will fail to cause any increase in aggregate output because the economy is already using its available resources fully and producing its potential output.

Short run macroeconomic occurs at the price level at which AD = AS.

AD P2 P0 A E B

AS

At point E where AD intersects AS at P0 price level and real GDP is Y0, short-run equilibrium is reached.

P1

Aggregate Output (Real GDP)