During 2005, the Federal Reserve Bank raised interest rates in an effort to prevent an increase in the rate of inflation.

a. What direct effects do higher interest rates have on household and firm behavior?

b. One of the consequences of higher interest rates was that the value of existing bonds (both corporate bonds and government bonds) fell substantially. Explain why higher interest rates would decrease the value of existing fixed-rate bonds held by the public.

c. Some economists argue that the wealth effect of higher interest rates on consumption is as important as the direct effect of higher interest rates on investment. Explain what economists mean by “wealth effects on consumption” and illustrate with AS/AD curves.