What is the interest rate effect?
- The change in aggregate demand in an economy due to changes in interest rates. It is the change in borrowing and spending behaviors
- If prices rise, then the value of money goes down, meaning the demand to borrow money will increase and ultimately drive up interest rates.
- When interest rates drop, then prices also fall
- Low interest rates stimulate economic activity, while high interest rates act as a brake
Life Application/Analogy
Let’s say you own a lemonade stand and want to borrow money to expand your business. If interest rates are low, then it is enticing to take out a loan because the financing is affordable and you can spend more money. However, if interest rates are high, you will not want to borrow money because it will become more expensive, causing you to hold out on expanding your business.
How do I remember it?
Just think of low and high. If interest rates are low, you want to spend and borrow money. But if interest rates are high, it means everything is more expensive so you do not want to borrow or spend money.
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