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How does Interest Rates Affect AD?• Consumption – Many consumer goods are bought on credit, so an increase in interest rates discourages this as the price of borrowing has now gone up. So AD decreases. – Equally AD will increase if interest rates fall as saving is discouraged and borrowing is now more attractive
How does Interest Rates Affect AD?• Investment – Much of the investment is financed through borrowing so the same principle as consumption applies here. – LOW INTEREST RATE = HIGHER INVESTMENT
How does Interest Rates Affect AD?• Net Exports – Interest Rates can influence the value of a currency – This is due to the flow of Hot Money, the higher the interest rate the greater the flow the stronger the local currency gets. – A strong pound will lead to imports being cheaper, so consumers suck in imports, this leads to a trade deficit and a low net exports – Exports as a result of a strong pound are now more expensive
Interest Rates & Inflation• Interest Rates can be used to help a central bank reach an inflation target• A higher interest rate will mean inflation is lower• A lower interest rate will mean inflation is higher• This can be observed on a AD/AS Curve
Interest Rates & Unemployment• A tightening of monetary policy (raising interest rates) will lead to unemployment due a fall in output• A loosening of monetary policy (lowering interest rates) would increase employment due a rise in output
Interest Rates & Current Account• If Interest Rates are high then it lowers AD which discourages the purchase of Imports which means the trade balance would look favourable• Lower interest rates would lead to a rise in AD so consumers suck in imports, which makes the trade balance worse