Chapter 26: Problem 1

Briefly discuss how an increase in interest rates affects each component of aggregate demand.

Short Answer

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An increase in interest rates affects each component of aggregate demand (AD) negatively. Consumption and investment decrease as borrowing becomes more expensive. Government spending might also decrease due to higher borrowing costs. Finally, net exports decrease because the domestic currency might appreciate, making domestic goods more expensive for foreign consumers and foreign goods cheaper for domestic consumers.

Step by step solution

Impact on Consumption

An increase in interest rates means borrowing is more costly. This discourages consumer spending, reducing the component of consumption in aggregate demand. Consumers may decide to save more because they receive higher returns on their savings. On the other hand, for those with existing loans (mortgages, for example), their repayments will increase, leaving them with less disposable income to spend.

Impact on Investment

Businesses invest in projects if the expected rate of return exceeds the cost of the investment. Higher interest rates increase the cost of borrowing, so many investment projects become unprofitable. As a result, businesses reduce their level of investment, leading to a decrease in the investment component of aggregate demand.

Impact on Government Spending

Higher interest rates also mean it's more expensive for the government to borrow money. In response, the government may decide to cut back on spending, which will reduce the government spending component of aggregate demand. However, it's also possible that government spending remains unchanged. This depends on the government's fiscal policy.

Impact on Net Exports

An increase in interest rates can lead to an appreciation of the domestic currency as foreign investors might move their assets to the country to take advantage of the higher rates. This makes domestic goods more expensive for foreign buyers, reducing exports. At the same time, foreign goods become cheaper for domestic consumers, increasing imports. Both of these effects lead to a decrease in net exports, the last component of aggregate demand.

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