An increase in interest rates will lead to a rise in the cost of production in the economy which will not result in a decrease in aggregate supply.

Introduction

Interest rate is the cost of borrowing and the reward for lending. Aggregate supply is the total supply of goods and services in the economy over a period of time and is determined by the production capacity and the cost of production in the economy.

Many students think that an increase in interest rates will lead to a rise in the cost of production in the economy which will result in a decrease in aggregate supply. Mr. Edmund Quek will discuss this economic misconception in greater detail with the students in economics tuition.

Exposition

Firms employ factor inputs to produce output. These factor inputs include plants and machinery which are often financed through loans. As an increase in interest rates will lead to an increase in interest payments on loans, the cost of production in the economy will rise. Many students think that this will lead to a fall in aggregate supply. This is erroneous. To understand this, we simply need to draw a distinction between fixed costs and variable costs. Fixed costs are costs that do not vary with the output level. In other words, an increase in the output level will not lead to an increase in fixed costs. Fixed costs will be incurred even if the firm shuts down production. Examples of fixed costs include interest payments on loans for the purchase of capital goods, insurance premiums and rent. Variable costs are costs that vary directly with the output level. In other words, an increase in the output level will lead to an increase in variable costs as more variable factor inputs are needed to produce more output. Variable costs will not be incurred if the firm shuts down production. Examples of variable costs include the costs of materials and labour. In the short run, firms do not take into consideration fixed costs when making output decision as they do not change with the output level. Firms take into consideration only variable when as they change directly with the output level. Although an increase in interest payments on loans will lead to a rise in fixed costs, it will not affect variable costs. Therefore, although an increase in interest rates will lead to a rise in the cost of production in the economy, it will not affect aggregate supply.

Economics Tuition Singapore @ Economics Cafe
Principal Economics Tutor: Mr. Edmund Quek