Most investment expenditures by the business sector and a fair amount of consumption expenditures by the household sector (especially for durable goods) are made with borrowed funds and are thus affected by changes in interest rates.

• Businesses typically borrow the funds needed for capital goods, such as factories and equipment.


• Households often borrow the funds used to buy durable goods, such as cars and furniture.

What It Does

Interest Rates

Lower Interest Rates

A decline in interest rates can entice the business sector to boost investment expenditures. For example, a 1 percentage point interest rate decline (such as from 10 percent to 9 percent) can reduce the total interest cost on a $10 million construction loan by $300,000 over a five-year repayment period. This saving is bound to convince a few firms to undertake extra investment expenditures.

While the numbers might be smaller, a decline in interest rates is also likely to entice the household sector to boost consumption expenditures on durable goods. For example, a 1 percentage point interest rate decline can reduce the total interest cost on a $20,000 car loan by $6,000 over a five-year repayment period. This reduction in cost is also bound to convince a few households to make extra consumption expenditures.

To see how lower interest rates affect the aggregate expenditures line, click the [Lower Rates] button. The lower rates trigger an increase in aggregate expenditures, which is an upward shift of the aggregate expenditures line.

Higher Interest Rates

To see how higher interest rates affect the aggregate expenditures line, click the [Higher Rates] button. The higher rates trigger a decrease in aggregate expenditures, which is a downward shift of the aggregate expenditures line.

What Does It Mean?

• Business Cycle: Interest rates tend to rise and fall over the expansions and contractions of the business cycle. During an expansion, especially near the end of the expansion, interest rates tend to rise. Then once a contraction sets it, interest rates tend to fall. In fact, these interest rate changes are part of the "natural" business cycle mechanism. Higher interest rates during an expansion cause the decline in aggregate expenditures that result in a contraction. Lower interest rates during a contraction then cause the rise in aggregate expenditures that result in an expansion.


• Monetary Policy: Interest rates are also affected by monetary policy that is designed to counter business-cycle instability. Expansionary monetary policy involves lower interest rates intended to increase aggregate expenditures and offset a contraction and address the problems of unemployment. Contractionary monetary policy involves higher interest rates intended to decrease aggregate expenditures and offset an expansion and address the problems of inflation.