Identification

Aggregate demand is a macroeconomic term referring to the total goods and services in an economy at a particular price level. Plotting these two on a graph produces what’s called an aggregate demand curve, reflecting the fact that prices and demand are subject to change. The AD curve has a downward slope, because as prices rise, demand for goods and services decreases. Interest rates represent the cost of money, and therefore have an effect on prices and aggregate demand.

Effects

Changes in interest rates can affect several components of the AD equation. The most immediate effect is usually on capital investment. When interest rates rise, the increased cost of borrowing tends to reduce capital investment and, as a result, total aggregate demand decreases. Conversely, lower rates tend to stimulate capital investment and increase aggregate demand.

Function

Changes in the interest rate can also have a profound effect on consumer spending. Most people borrow money to buy things such as houses and cars, and a higher interest rate increases the total cost of the purchase (price), and therefore can reduce the total amount of such borrowing and spending. Consumer spending is the largest component of aggregate demand in the United States, so fluctuations can have a large effect on the overall economy.

Significance

References

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