Interest rates and price levels are linked, with the central bank using interest rates to control price levels. Raising interest rates reduces consumer access to credit, leading to a decrease in demand and prices. Lowering interest rates can stimulate demand and increase prices.
The price level and the interest rate are linked in the sense that manipulation of the interest rate level is one of the tools used by the central bank or the government to control price levels in an economy. The central bank of a country uses interest rates as one of its main tools to increase or decrease price levels, both for different purposes. When the price level is too high, the central bank will raise interest rates. When the price level is too low, the central bank will lower interest rates.
Raising the interest rate affects the aggregate price level in an economy by reducing the ability of consumers to easily obtain money from banks. Normally, central banks aim to keep interest rates at a predetermined low percentage as much as possible. When the market is too active and excessive demand for goods and services begins to drive up the prices of such items, the central bank will seek to reduce activities in the market. The price level and the interest rate are linked by the fact that an increase in interest rates will cause a decrease in the price of goods.
As interest rates rise, consumers won’t 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 so will prices. This link between the price level and the interest rate means that the fall in demand caused by the increase in interest rates will lead to a situation where supply will exceed demand. Normally, when the supply is more than the demand, the prices of goods and services will fall in response.
Another relationship between the price level and the interest rate can be seen in a situation where there is deflation or the price level is lower than average. Such a situation is usually the result of too low demand by consumers for the finished products on the market. In this situation, the central bank will lower interest rates in an effort to induce consumers to get more money from banks and make more purchases. When the central bank lowers interest rates, other banks also react by lowering interest rates on savings accounts, making it less attractive for customers to save money.
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