Answer to Question #137251 in Macroeconomics for OWUSUAA

Question

Assume that the central bank announces a rise in interest rates and backs this up with open market operations. What determines the size of the resulting fall in aggregate demand?

Answer 1

When  central bank increase interest rates it becomes expensive to borrow money. The borrowed money would basically go towards capital investment and consumer expenditures , hence these two sectors diminish under increased interest rates. For this reason, aggregate demand falls. On the other hand, when the central bank allows the operation of open markets buying and selling of government bonds is allowed hence banks acquire money to lend out. As a result, money supply increases and interest rates fall. When interest rates fall investment spending and consumption rise hence making the aggregate demand to rise as well as GDP.