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Interest rate changes & Aggregate Demand

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\percent_symbol.jpgThe impact of changes in interest rate on Aggregate Demand

(refer to Tranmission diagram on page 152) Interest rate changes will affect aggregate demand. For example, if interest rates rise, the impact on aggregate demand will be:

  • Consumption - if interest rates are increased then consumers will find that their disposable income is lower (because debt repayments and mortgage repayments will be higher) and they will be less likely to borrow as it is more expensive. This will reduce their consumption. Higher interest rates also make saving more attractive than consuming.
  • Investment - higher interest rates will make investment less attractive, as the cost of borrowing and the returns are relatively lower.
  • Government expenditure - government also often borrow large amounts of money and if interest rates rise then they will face higher 'debt servicing' costs (higher interest payments).
  • Exports and imports - an increase in interest rates may lead to a rise in the exchange rate and this will make exports less price competitive. Exports may fall and imports may rise. However, an increase in interest rates may reduce the overall level of demand and thus the demand for imports in particular.

The aim of monetary policy is generally to manage the economy without causing sudden increases in either inflation or unemployment. Price stability is now central to macroeconomic policy, although following the financial crisis in 2008, and the resultant recession, some governments appear to be prepared to allow inflationary pressures to build (following cost push pressures from increase in commodity prices) and adopt expansionary fiscal and monetary policies in an attempt to avoid a recurring recessions and depressions. Many governments borrowed large amounts to finance expansionary policies in response to the credit crunch and are now having to make large cuts in their government spending in order to pay back the debts incurred.

A successful monetary policy allows for price stability and maximum employment. It should also allow supply-side policies to work. This will be covered in the next section 2.6