Along the Curve

Before examining the details of the interest-rate effect, consider the specifics of what it does. A typical aggregate demand curve is presented in the exhibit to the right. The negative slope of the aggregate demand curve captures the inverse relation between the price level and aggregate expenditures on real production.

When the price level changes, the interest-rate effect is activated, which is what then results in a change in aggregate expenditures and the movement long the aggregate demand curve. To illustrate this process, click the [Change Price Level] button.

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. Businesses typically borrow the funds needed for capital goods like factories and equipment. Households often borrow the funds used to buy durable goods like cars and furniture. The cost of borrowing these funds depends on the interest rate. A higher interest rate can add to the overall cost of the expenditure. A lower interest rate can reduce the overall cost of the expenditure.

This means that changes in the interest rate can have a big impact on consumption and investment spending. The interest rate tends to increase and decrease as the price level increases and decreases. This means that a higher price level induces a higher interest rate which raises the cost of borrowing and discourages investment and consumption spending. A lower price level has the opposite result.

Suppose, for example, that Duncan Thurly is primed and ready to buy a brand new OmniMotors XL GT 9000 Sports Coupe. Because this purchase will set him back over $20,000, which exceeds his available bank account balance, he plans to borrow the necessary funds. A four-year loan with a 10 percent interest rate, would result in monthly payments of $507, an expense he can handle. However, a boost in the price level that increases the interest rate on this loan to 12 percent results in monthly payments of $527. This extra $20 causes Duncan to pause and rethink this planned purchase. If he decides the extra expense is too much, then he has fallen victim to the interest-rate effect.