Explain how the central bank can change interest rates to manipulate Aggregate Demand.

The key concept here is that interest rates essentially represent the price of money. The central bank sets the interest rate to loan to high-street banks, and the high-street banks follow this guidance to set the price for customers. A bank will pay a saver a percentage of the amount they have in an account as a reward for saving with them. This percentage is the interest rate. Equally, if a firm would like to borrow money from the bank, the interest represents by how much more than the original loan the bank expects in payment. This can then affect both investment and consumption.This affects Consumption as savers earn a reward for saving, and so if the interest rate is relatively high, they are encouraged to keep their money in the bank, and earn more from it, month on month. If interest rates are lowered however, the incentive to save becomes smaller, and so households will be encouraged to spend instead, as there is a weaker reason to save. Spending is the same as Consumption, and so as interest is lowered, spending (consumption) increases, and as Consumption is component of Aggregate Demand, AD will increase in the short run.NB- The central bank wants to avoid the liquidity trap, where the interest rate is so low, the impact of reducing it further is minimal.Investment is affected in reverse. If the interest rates rise, it becomes more expensive for them to take out a loan, as they will have to pay back more. Consequently, they are less likely to invest, as the cost to them will be greater. Conversely, a lowering of interest rates means that it is cheaper and so more firms could afford to take out a loan, which in turn they will invest. Therefore, as Investment is also a component of Aggregate Demand, a lowering of interest by the central bank will result in increased investment and, following this, an increase in AD.