Microeconomics Question from Walter E. Williams:Edit

"A rise in the interest rate tends to moderate aggregate demand and so is anti-inflationary. But interest is a cost of business and the increase in cost tends to raise prices. Hence on balance it is not clear whether a rise in the interest rates tends to counter inflation." Analyze.


This is a classical problem of income and substitution effects. The problem here is that theory can not tell us which will dominate in all cases. As the interest rate rises, consumers will substitute away to lower cost goods that don't require borrowing and toward saving. Firms will follow suit, lowering investments to lower costs. However, there will also be an income effect - consumers feel wealthier than they previously did because they are now earning higher rates of return. Which effect dominates will depend on the individual situation and whether the goods being purchased are normal or inferior.

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