Final answer:
The interest rate effect explains how rising output prices cause higher interest rates, reducing investment and consumption spending, leading to a possible shift of AD to the left and potential recession.
Step-by-step explanation:
The interest rate effect is a key component of the downward sloping aggregate demand (AD) curve, which illustrates the inverse relationship between the price level and total spending in the economy. As prices for outputs rise, the public requires more money or credit for purchases. The increased demand for money and credit leads to higher interest rates, consequently reducing investment spending by businesses and consumption spending by households, as borrowing costs become prohibitive. This can result in a contraction of aggregate demand, shifting the curve to the left, which could potentially lead to a recession if total spending falls below the economy's potential GDP.