A local government decides to increase infrastructure spending significantly, anticipating that it will boost economic activity. In response, the central bank raises interest rates to control potential inflation. How does this scenario illustrate the relationship between aggregate demand and interest rates, particularly concerning bond prices?

In this scenario, the local government's increased spending is expected to raise aggregate demand, which is the total amount of goods and services people want to buy in the economy. When aggregate demand goes up, it can lead to higher prices, or inflation, so the central bank raises interest rates to keep inflation in check. Higher interest rates make borrowing more expensive, which can reduce spending by consumers and businesses, slowing down aggregate demand. As interest rates rise, bond prices typically fall because new bonds are issued at higher rates, making existing bonds with lower rates less attractive. For example, if a new bond offers 5% interest while an older bond offers only 3%, investors will prefer the new one, causing the price of the older bond to drop.