Final answer:
Interest rates significantly influence economic activity by affecting borrowing costs for consumers and businesses, which in turn impacts investment spending and overall economic growth.
Step-by-step explanation:
Interest rates are crucial in explaining economic activity as they directly impact the cost of borrowing. For businesses, this determines the expense involved in financing large purchases, which includes not only the principal amount but also the interest rate. When interest rates are low, firms are more likely to invest in business capital, as the opportunity cost is reduced, leading to stimulated investment spending. Conversely, high interest rates make borrowing expensive, reducing investment and consumption by businesses and households alike. This can lead to a decrease in overall economic activity.
The interest rate effect also comes into play in a broader economic sense. As prices increase, more money or credit is demanded, elevating interest rates, which in turn dampens borrowing and spending. The Federal Reserve manipulates interest rates as part of its monetary policy to manage inflation and stimulate the economy, highlighting the importance of interest rates in economic conditions.