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How does a change in interest rate impact aggregate demand in an economy?

The components of aggregate demand are: consumption, investment, government spending and net exports. An increase in interest rate makes it more attractive to save money (not spend) and less attractive to borrow as the payback rate will be higher; therefore consumption in the economy falls. A higher interest rate will also decrease investment in the economy as there is less borrowing which implies less spending on investment projects. However, the increase savings rate could counteract this as savings in commercial banks are then loaned out to fund investment projects. Net exports would be affected by an increase in the interest rate as a higher interest rate causes the pound (in the UK) to become stonier as it is a more attractive currency so demand for it increases. A stronger pound will make exports less competitive and imports cheaper so net exports will decrease. The combined effect of lower consumption, investment and net exports will cause aggregate demand to decrease if interest rates rise.



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