INTEREST RATES

The Price of Liquidity

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

•Strong

•Pound

•Imports

•Cheaper

•Exports

•Dearer

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

AD2

AD1

AD3

Y1Y2 Y3

PL1

PL3

PL2

LOW INTEREST RATES

HIGH INTEREST RATES

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