Economics – Government and the macroeconomy - Inflation | e-Consult

Answer:

A decrease in interest rates makes borrowing cheaper for both consumers and businesses. This encourages increased spending and investment, leading to an increase in aggregate demand (AD). This increase in AD, if not matched by a corresponding increase in aggregate supply (AS), results in demand-pull inflation.

Consumers are more likely to take out loans to buy houses, cars, or other goods and services. Businesses are more likely to invest in new equipment or expand their operations. This increased spending directly contributes to a higher level of AD. As AD rises, businesses face greater demand for their products and can therefore increase prices. This upward pressure on prices is demand-pull inflation.

The AD-AS model demonstrates this. A decrease in interest rates shifts the AD curve to the right. If AS remains constant, the equilibrium price level will rise. The magnitude of the price increase will depend on the responsiveness of AD to changes in interest rates (the price elasticity of demand).

Key Concepts: Interest Rates, Aggregate Demand, Aggregate Supply, Investment, Consumer Spending, AD-AS Model, Price Elasticity of Demand