Question

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

Short answer

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.

Key concepts

Interest Rates

Interest rates play a crucial role in shaping aggregate demand. They are the cost of borrowing money. When interest rates rise, borrowing becomes more expensive for both consumers and businesses.
This leads to a decline in spending. For example, a person may decide against taking a loan for a new car because repayments are unaffordable.
It's possible more of their budget would go towards higher payments on existing debts.

• Consumers are discouraged from borrowing.
• People might save more because of higher returns on savings.
• Loan repayments become more costly.

This cascade of effects can cause a slowdown in economic activity as aggregate demand decreases.

Consumption

Consumption refers to the purchasing of goods and services by households. It's a major part of aggregate demand. When interest rates increase, the immediate impact is usually a reduction in consumption.
Higher borrowing costs mean that loans for big purchases, like cars and homes, are less popular.
Moreover, people with existing loans might find their monthly payments are now higher, leaving less money for spending on other things.

• High interest rates encourage people to save more.
• Saving increases when returns on savings accounts grow.
• Greater loan repayments reduce disposable income.

As savings become more appealing than spending, overall consumption tends to fall.

Investment

Investment, in economic terms, involves businesses spending money on capital goods to generate future income. It's highly sensitive to changes in interest rates.
When these rates rise, the cost of borrowing for new investments goes up.
As a result, fewer projects meet the profitability threshold needed to justify investment.

• Businesses face higher costs for financing projects.
• Return on investment must exceed the cost to be viable.
• Fewer investments lead to a decrease in economic growth.

With fewer profitable investment opportunities, businesses often cut back on spending, thus reducing the investment component of aggregate demand.

Net Exports

Net exports are the value of a country's exports minus its imports. Changes in interest rates also affect this component of aggregate demand.
When interest rates increase, it often leads to an appreciation of the national currency. This appreciation makes a country’s goods more expensive for international buyers, reducing exports. At the same time, foreign goods become cheaper for domestic consumers, increasing imports.

• Stronger currency makes exports dearer.
• Domestic consumers might spend more on imports.
• Overall, higher interest rates can reduce net exports.

In essence, while local consumers benefit from cheaper imports, the overall effect is a decline in net exports, impacting aggregate demand negatively.