Does the international substitution effect help explain the slope of the aggregate demand curve?
The international substitution effect supports a connection between price and demand only in limited circumstances. A fixed exchange rate is necessary before domestic goods prices and quantity can be directly linked. A flexible exchange rate renders the substitution effect incomplete or nonexistent. The effect can therefore lead to fallacious conclusions not encountered with general equilibrium approaches. Macroeconomics textbooks typically offer three separate and distinct explanations for the downward slope of the aggregate demand (AD) curve: (1) the interest rate (or Keynes) effect, (2) the real balance (or Pigou) effect, and (3) the international substitution effect. The underlying model of aggregate demand is not always clear, especially in principles textbooks,…
