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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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