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Explain how a reduction in interest rates affect AD.

Interest rates are the cost of borrowing money expressed as a percentage of the amount borrowed. A reduction in the bank rate by the MPC (Monetary Policy Committee) would result in banks offering lower interest rates to consumers as the cost of them borrowing money would decrease. As such, this would decrease the cost of borrowing for consumers as a lower proportion of their income will be spent on repayments for example, and would thus result in their marginal propensity to consume increasing. Furthermore, there will be an increase in the incentive to borrow money as you can now borrow more cheaply, and this coupled with the fact that the rate of return on savings now falling, would result in a rise in consumers’ marginal propensity to consume. Since consumption is a major determinant of AD (consumption comprises of around 66% of AD), AD would shift right from AD1 to AD2, resulting in demand pull inflation increasing from PL1 to PL2, and an increase in RNO from Y1 to Y2, which would ultimately result in a rise in real GDP and thus economic growth.



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