Business, Politics, & Society

Interest Rate Effect: Definition, Examples, and Relation to Aggregate Demand

Written by MasterClass

Sep 11, 2019 • 4 min read

From time to time, government bodies that set monetary policy (such as the United States Federal Reserve, also known as the Fed) will adjust national interest rates as they work toward a goal of sustained economic growth. When interest rates are adjusted, banks, consumers, and borrowers may alter their behavior in response. The way that rate adjustments motivate such behavior is known as the interest rate effect.

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What Is the Interest Rate Effect?

The interest rate effect is the change in borrowing and spending behaviors in the aftermath of an interest rate adjustment.

As a general rule, when interest rates are set by a nation’s central bank, consumer banks extend similar interest rates to their clientele (while adding in additional interest that serves as their profit margin).

When a central bank lowers the interest rate, consumer banks lower their own rates, and this typically prompts businesses and individuals to borrow more money. After all, the cost of borrowing is “cheaper” if the borrower owes less in monthly interest payments.

How Is the Interest Rate Effect Related to Aggregate Demand?

The relationship between interest rates and aggregate demand is a crucial topic within macroeconomics, which is the study of economics on a large scale. A nation’s aggregate demand represents the value of that nation’s goods and services at a particular price point.

As a general rule, when prices rise, demand falls because there is less of a market to purchase goods at expensive prices. By contrast, when prices fall, consumers gain more purchasing power; as a result, demand increases.

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What Is the Interest Rate Effect Formula?

Economists calculate aggregate demand using the formula:

AD = C + I + G + (X-M)

In this formula:

  • AD represents aggregate demand
  • C represents the nation’s consumer expenditures on combined goods and services
  • I represents the nation’s total capital investment
  • G represents the nation’s total government spending
  • (X-M) represents the net total for the nation’s exports

How Does the Interest Rate Effect Impact Aggregate Demand?

Here is how interest rates affect aggregate demand:

  • When interest rates rise, it becomes more “expensive” to borrow money. That borrowed money would typically go toward consumer expenditures and capital investment, and so these two sectors diminish under higher interest rates. Therefore aggregate demand decreases, per the equation.
  • When interest rates fall, the opposite happens. Businesses and individuals are able to borrow money at affordable rates. This borrowed money is invested in consumer purchases and capital (such as real estate or start-up business expenses), and aggregate demand accordingly rises.

Of course, when a nation’s central bank charges a higher interest rate, it theoretically receives more long-term revenue, as borrowers make monthly or quarterly interest payments. This then gives the government more money for its own expenditures. However, macroeconomists have determined that this potential for increased government spending rarely supersedes the decrease in consumer spending and capital investment. Therefore, increased government spending is rarely enough to tilt aggregate demand back in the positive direction.

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Example of the Interest Rate Effect

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To see how the interest rate effect works in the real world, consider the housing market. A house will be the most expensive purchase of most people’s lives. Few Americans have enough cash savings to buy a house outright, so instead they make a cash down payment, and they borrow the rest of the cost from a bank, which charges them interest.

  • Let’s say someone bought a house for $400,000 and had the chance to borrow that sum at a 4% annual interest rate. This would mean that they would owe 4% of $400,000—which is $16,000—to the bank every year (although typically the interest amount decreases as they pay down more of the principal borrowed sum).
  • Now, let’s say the Federal Reserve raised interest rates by 0.25%. This means they charge consumer banks a greater rate to borrow money, and the consumer banks pass this rate hike along to their customers.
  • This means that our theoretical homebuyer would now owe $17,000 in annual interest payments, instead of just $16,000. That extra $1,000 per year may push them out of their financial comfort zone and dissuade them from purchasing the house altogether.

When many potential borrowers nationwide come to that same conclusion—that the house is now too expensive once you factor in the cost of borrowing—it leads to an overall decrease in aggregate demand. Indeed, interest rates and consumer behavior tend to run hand in hand.

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