Price level and interest rate are linked together in the sense that the manipulation of the level of interest rates is one of the tools used by the central bank or government to control price levels in an economy. The central bank in a country uses interest rates as one of its main tools for either increasing or decreasing price levels, both to different effects. When the price level is too high, the central bank will increase the interest rates. When the price level is too low, the central bank will decrease the interest rates.
Increasing the interest rate affects the level of the aggregate price in an economy by reducing the capacity of consumers to obtain money with ease from banks. Normally, central banks aim to maintain the interest rates at a predetermined low percentage as much as possible. When the market is too active and the excessive demand for goods and services start to push the prices of such items ever upward, the central bank will seek to curtail the activities on the market. Price level and interest rate are linked together by the fact that an increase in the interest rates will cause a decline in the price of goods.
By increasing the interest rates, consumers will not have the same easy access to different types of credit and loans, which they can use to finance purchases like cars, clothes, houses and other items. When consumers no longer have the means to pay for such things, the demand for them will drop and the prices will drop too. This link between price level and interest rate means that the drop in demand caused by interest rates increase will lead to a situation where the supply will outweigh the demand. Normally, when the supply is more than the demand, the prices of goods and services will drop in response.
Another relationship between price level and interest rate can be seen in a situation where there is a deflation or the price level is lower than average. Such a situation is usually the outcome of too little demand on the part of consumers for the finished products in the market. In this situation, the central bank will decrease the interest rates in an effort to induce consumers to obtain more money from banks and make more purchases. When the central bank decreases interest rates, other banks also react by decreasing the interest rates on savings account, making it less enticing for customers to save money.
