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Monetary Policy - How Rising Interest Rates affect Aggregate Demand

AS, A-Level, IB
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 11 Feb 2023

In this study video we look at how a period of rising interest rates can affect one or more of the components of aggregate demand.

Monetary Policy - How Rising Interest Rates affect Aggregate Demand

Economic Effects of Higher Interest Rates in the UK

  1. Consumer Spending: Higher interest rates make it more expensive for households to service their debts, reducing effective disposable income.
  2. Household Saving: The return on saving usually rises – leading to an increase in the propensity to save and a fall in consumer demand
  3. Investment: Higher interest rates make borrowing more expensive for firms, which can reduce their investment in new capital
  4. Exchange Rates: A rise in interest rates can lead to an appreciation of the domestic currency, making exports more expensive and imports cheaper. This can lead to a decrease in aggregate demand as firms and consumers reduce spending on foreign goods
  5. Asset Prices: Higher interest rates can also reduce the value of assets such as stocks, bonds, and housing, leading to a decrease in aggregate demand as households reduce spending in response to lower wealth.

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