But there are a few factors, which can determine these components. The most important factor which might determine each of the aggregate demand components is the consumers’ confidence. So if this confidence decreases for any reason the consumers are not longer willed to purchase as many goods as before, which in turn reduces the household expenditure massively. The companies might feel less confident as well and will also reduce their investment. Then the government has to react, to get the confidence up again, so they would increase their expenditure to push the consumers across that they have no doubt that the actually economic situation will go up again. Moreover the imports will be reduced, because there is not the same quantity demanded as before and even the exports might reduce, because of the companies less confidence, they might lower their production. So the confidence plays quite a big influencing role.
Another influencing factor could be a sudden boom in the housing market, which would cause a chain of effects. So at first the consumers have indirectly more money, because their house has now a bigger merit than before. Therefore they would increase their household expenditure. Furthermore the companies would also increase their investment spending – especially on buildings – because they now see a huge potential in this business. On the other hand the government spending would decrease, because they would try to demagnetise the boom to minimize the level of inflation. The imports would probably rise, because of the greater spending of money by the consumers. The only component which would maybe stay the same is the export component. But even if it stays the same, the net exports would still change.
That is the reason why the government plays such a big part in the aggregate demand, so that they can avoid that such factors influences the components that massively.
b) There would be a few impacts on the economy if the level of interest rates increases substantial, but it depends on the current economic situation. We could have three different assumptions:
1. When the economy is in a boom period and the inflation level is high.
2. When the economy is solid.
3. When the economy already has a bust.
In the first situation the economy would cool down and come to a normal level of consumption and inflation. The only problem here would be for the trade partners, which are still producing a great number of goods although they are not wanted in such a quantity anymore. So the level of demand and supply decreases, to a point with quite high RGDP and output, but with now a low level of inflation.
In the second situation we begin from the best economic wealth point (which will decrease to a much lower level of RGDP and output). Therefore the first consequences would here be that the housing market decreases, because less people are able and willed to buy a house with such high interest rates, which in turn decreases the consumers’ confidence and also reduces their expenditure on goods, because their assets are less worth (also a fall in imports). The companies have to pay more for their buildings (capital goods) as well and then have probably less to invest ( -> less exports). The result would be a bust in the economy. Therefore our exports are less expensive for the consumers in the other countries, because of the better exchange rate and the imports are more expensive. Then the government would react with many high injections to get a firm market. The problem is, even if all conditions are given now, if the consumer doesn’t have the confidence to buy, the economy would still decrease and the money which the government spent in the circular flow of income would be useless.
In the third situation the economy would be in a totally standstill. So the economy is already in a bust period and would still decrease, which would cause a recession and would make the consumers even less confident then before so that they would consume less as well. That would have a grave effect on the country’s economy, which is sometimes unstoppable, which in turn could lead to a currency depreciating.
So as a conclusion a substantial rise in interest rates can have two different effects. On one hand it can calm the economy down if the fear of inflation is too big and if there is no potential economy gap left, but on the other side in every other situation it would drag the economy down and reach lower supply and demand points than before. Therefore the general most likely impact of higher interest rates is, that the economy reaches a level with a lower productivity (lower demand and supply level).
by
joachim (student)
