Which of the following best describes the effect of interest rates on demand?

The effect of interest rates on demand primarily relates to how they influence the cost of borrowing and the return on savings. When interest rates rise, the cost of borrowing money increases, which can lead to higher monthly payments for loans and mortgages. As a result, consumers may have less disposable income to spend on goods and services, effectively decreasing their purchasing power.

Conversely, lower interest rates typically lead to cheaper loans, encouraging consumers to borrow more and spend more on discretionary items. A decrease in purchasing power due to higher interest rates can temper consumer demand, particularly for bigger-ticket items that often require financing, such as homes and cars.

Therefore, the correct understanding of why rising interest rates can dampen demand is reflected in the notion that they decrease the purchasing power of consumers, making it more challenging for individuals to afford various goods and services.