Monetary Policy - Interest Rates and Aggregate Supply

To what extent can changes in interest rates affect short run and long run aggregate supply in an economy?

How might higher interest rates affect aggregate supply?

Monetary policy is an example of a demand-side policy that seeks to influence the level and growth of aggregate demand.

But changes in interest rates and exchange rates can also have an impact on the supply-side of an economy, for example by impacting on planned business capital investment.

1. When interest rates rise, it becomes more expensive for firms to borrow money for capital investment, causing a decrease in investment and hence a possible decrease in long run aggregate supply.
2. A drop in investment means that an economy’s capital stock will age possibly leading to a fall in productivity / efficiency
3. Higher interest rates can reduce the profitability of businesses (borrowing costs are increased and consumer demand contracts). If profits decline, then businesses may have less to spend on research and development and innovation which might then lead to lower labour productivity.

Evaluation

• Higher interest rates usually cause an appreciation of the exchange rate. This can allow domestic businesses to buy imported capital equipment / software and hardware at a lower price. This might cause capital spending to rise.
• Higher interest rates are designed by a central bank to help control inflation. If this policy is successful, then lower inflation will help to improve macroeconomic stability and business confidence. This in turn can help promote investment demand.
• Higher interest rates can encourage households to save more money, which can increase the pool of funds available for lending to businesses, potentially making it easier and cheaper for them to access financing.