Interest Rate Theories - Affecting Demand - How does the interest rate affect demand?

The key to using the interest rate to help economic management is the effect that interest rates have on demand. If the Bank of England feel that inflationary pressures are rising in the economy then they will increase the rate of interest to dampen down the growth of aggregate demand.

Demand falls when interest rates are raised through their effect on the components of aggregate demand. Aggregate demand is made up of the following types of spending:

Of these, the first two in particular will be affected by interest rate changes.

Consumption

Consumption will fall when interest rates are raised. This happens for two reasons. The first is that it is now more expensive to borrow money. This will put people off borrowing, and lower borrowing means lower spending. However, it is not just new borrowing that is affected, but also people who are still paying off existing borrowing. For many people their main investment is their house. To buy this they are quite likely to have taken out a mortgage and higher interest rates means higher mortgage payments. These reduce their disposable income and so leaves them with less money each month to spend. The same will be true for people who have borrowed to buy other things as well.

Investment

To invest many firms will, like people, have to borrow. They will borrow if they think that the rate of return on their investment is greater than interest rates. If interest rates rise then fewer investment projects are likely to be viable, because with the higher cost of borrowing they are now less profitable. The rise in interest rates will therefore reduce the level of investment. The amount investment falls by depends on the interest elasticity of demand for investment.