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How would an increase in interest rates impact aggregate demand

An increase in interest rates would impact aggregate demand (AD) by impacting consumer spending, business investments and exports-imports. When interest rates rise borrowing becomes more expensive and saving become more profitable. Therefore, if interest rates were to increase we would expect to see both businesses and consumers borrowing less and spending more. This in turn would result in lower levels of business investment in things such as research and development as well as a decrease in consumer spending. Since business investment and consumer spending are two crucial aspects of the AD formula, when they fall so too will AD. Further, when interest rates rise one might expect to see a rise in foreign direct investment (FDI) due to foreign firms believing they can gain greater returns on their investments. This would lead to an appreciation of the currency, making the nation’s exports more expensive to foreign consumers and giving domestic consumers more purchasing power. Therefore, imports would increase whilst exports decrease. Since AD is in part measured by how much a nation can export in relation to its imports, we would expect this sequence of events to lead to a fall in AD signified by a shift of the AD curve to the left. However, there are various things that might outset these outlined effects. For example, if consumer confidence is particularly high then consumer spending might not fall. The same applies to business confidence and business investment. Finally, if the goods a nation exports are particularly inelastic in terms of their PED then a fall in the value of exports may not occur, indeed it may even increase due to the appreciated value of the currency.

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