Interest Rate Effect on Aggregate Demand

by Victoria Duff

Aggregate demand is the total demand for goods and services in an economy. To find aggregate demand, add total consumer spending on goods and services to the amount of money spent by companies on working capital, plants and equipment, plus government spending and the amount of the trade deficit or surplus. There are two schools of thought regarding what affects aggregate demand: credit availability or the injection of money into the system.

Helicopter Ben

Federal Reserve Chairman Ben Bernanke acquired the nickname “Helicopter Ben” when he remarked that if he saw a depression forming in the economic system, he would flood the system with money and would even drop money from a helicopter. This reflects his view that the availability of credit is not as effective in spurring aggregate demand as is the direct availability of money. This is why he instituted massive government spending on bank and corporate bailouts and mortgage programs such as TARP, HARP and HAMP in response to the credit crisis of 2008 and 2009.

Fed Monetary Policy

Traditionally, when the Federal Reserve wants to expand the economy, it adds money to the system by lowering interest rates and injecting money into the system through open market operations to purchase U.S. Treasury securities in the bond market. In a 1988 paper published by The American Economic Review, Chairman Bernanke questioned the timely effect of making credit available as a means of quickly adding money to the system. His studies indicated that the lag time between easing credit availability and the growth of aggregate demand had lengthened since the Great Depression of the 1930s. For this reason, he argued, dropping cash into the system as needed is the best way to quickly spur aggregate demand.

Interest Rates

During normal economic times, lowering interest rates tends to increase aggregate demand, while raising interest rates decreases aggregate demand. When interest rates are low, banks are anxious to lend money because they need to write more loans to keep their revenues growing. This is because, during low-rate periods, the spread narrows between a bank's cost of deposits and its lending rates. During a credit crisis, however, banks are reluctant to lend to any but the highest credit-quality customers. For this reason, small business was shut out of bank financing in 2008 and the economic recession that followed. This kept money from reaching the consumer on Main Street; financially strapped consumers don't spend money on automobiles, nondurable goods or houses.

High Interest Rates

Raising interest rates discourages business and consumer borrowing and encourages saving. When businesses and consumers are conservative with their spending, aggregate demand decreases. Low aggregate demand is a feature of an economic recession, so the Federal Reserve acts to lower interest rates to encourage more business and consumer borrowing. This increases the supply of money in the system, if banks are lending. During a credit crisis, banks don't want to lend at low interest rates because they want to be compensated for the additional risk they are taking on those loans – loan defaults rise during economic crises. This is why the U.S. Government acted to inject money directly into the system through recovery programs such as TARP, HARP and HAMP, which subsidized bank lending to businesses and allowed mortgage refinance and modification to relieve economic stress on homeowners.

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